On 17 July 2026, the European Commission tabled its proposal to revise the EU Emissions Trading System (EU ETS), the bloc's flagship carbon market and the cornerstone of its climate policy. The ETS review process is mandated by the EU ETS Directive and provides for regular assessment of the system's performance and the introduction of necessary changes to finetune the system in the changing economic, political and technological landscape. The proposal sets the legal framework for Phase 5 of the system (2031-2040), aligning the ETS with the EU's target of a 90% net reduction in greenhouse gas emissions (GHG) by 2040 compared with 1990 levels. Coming as European industry contends with high energy costs and international competition, it marks one of the most consequential reviews of the carbon market since it was launched in 2005.
The proposal covers a variety of elements, including those that form part of the ETS formal evaluation and review and those that go beyond the strictly prescribed elements of the review process.
The cap trajectory and linear reduction factor (LRF)
In the released text, the Commission proposes setting an annual Linear Reduction Factor (LRF) of 3.7% for the period 2031-35 and an LRF of 1.7% from 2036 onward. The LRF is currently set at 4.3% for 2024-27 and 4.4% from 2028. The proposed shallower rate of cap decline is consistent with the EU’s 2040 target of a 90% net reduction (of which at least 85% domestic). As a result, allowances will continue to be issued into the 2040s rather than the supply of new allowances ending around 2039 as the current rules - if simply extended into Phase 5 - would have implied.
Market Stability Reserve (MSR)
The document also covers proposals to amend the MSR Decision by introducing a package that will keep the reserve calibrated to a shrinking EU ETS cap. Starting in 2028, the intake rate is halved from 24% to 12%, making more allowances available in the market for a longer period. Starting in 2029, the upper and lower thresholds, the release amount, and the lower buffer will decrease by a fixed 4% annually - becoming dynamic - to account for the gradually shrinking cap. A new lower buffer mechanism is introduced from 2028, replacing the current fixed 100-million release with a variable release equal to the gap between the lower threshold and the TNAC when the TNAC falls between the two thresholds, ensuring more proportionate responses to market conditions. Finally, the TNAC calculation is amended to incorporate the cumulative net aviation demand from 2012 to 2023 - reducing the 2027 TNAC figure by approximately 173 million allowances - making the reserve more responsive and triggering earlier allowance releases.
The current proposal supplements the amendment to the MSR put forward by the Commissions on April 1, 2026. The amendment would end the invalidation mechanism, under which allowances in the reserve above 400 million are currently cancelled, and instead retain those allowances as a buffer to support future market stability.
Free allocation conditionality and phase-out timeline
The proposal extends free allocation and carbon leakage protections - including transitional measures for energy-intensive industries (EIIs) - through 2040, with benchmark update rules covering the 2031–2035 and 2036–2040 periods and an increased cross-sectoral correction factor buffer of 4%.
From 2031, all free allocation is made fully conditional upon operators submitting a verified decarbonisation investment plan, with 80% of allowances released upon plan approval and the remaining 20% contingent on demonstrated emissions reductions by the end of each five-year period. Operators relocating activities outside the EU will be required to return allowances received under the relevant provision, directly incentivising investment retention within the EU.
For sectors covered by the Carbon Border Adjustment Mechanism (CBAM), 15% of phased-out free allocation is proposed to be reintroduced from 2028, slowing the CBAM phase-in and extending the free allocation phase-out to 2038 to manage residual carbon leakage risk.
International carbon credits
The proposal further operationalises the provisions of the revised European Climate Law, which establishes a binding 2040 climate target and provides for the use of a limited volume of high-quality international credits - developed under Article 6 of the Paris Agreement - to contribute towards that target from 2036 onwards, up to a ceiling equivalent to 5% of the EU’s 1990 net GHG emissions.
Specifically, up to 260 million allowances will be ring-fences from the Union-wide quantity and auctioned to generate revenues for the purchase of up to 260 Mt of high-quality, high-integrity international credits between 2036 and 2040 - equivalent to roughly 2% of the EU’s 1990 net GHG emissions and well within the 5% ceiling set by the Climate Law. The proposal establishes the financial architecture for this, including the establishment of a facility for purchasing international credits. Additional details left to future legislation that the Commission intends to bring forward later in 2026.
By January 2033, the Commission must report to the Parliament and the Council on the international credits market. The report will cover environmental integrity, verification, supply and demand, and EU ETS implications; if high-quality, high-integrity and cost-effective credits prove unavailable, the linear reduction factor would revert to 2.7% from 2036 - aligning the ETS with the full domestic ambition of 90% by 2040 - and the leftover set-aside allowances would be redistributed to the Industrial Decarbonisation Bank for industrial decarbonization projects.
Integration of domestic carbon removals
The proposal incorporates domestic permanent carbon removal units into the EU ETS by increasing the overall cap by 250 million allowances. These additional allowances will be auctioned by the Commissions between 2031 and 2040, with the revenue raised used exclusively to purchase BioCCS and DACCS certified under the Carbon Removals and Carbon Farming (CRCF) Regulation. An additional contingency reserve of 10 million allowances will be available for auctioning should revenues prove insufficient to cover the full purchasing cost.
Based on the current reading of the proposal, these removal units purchased would not enter the EU ETS directly, but would instead, 'back up' the extra issued allowances with certified emission removals. Operators that generate CRCF-certified BioCCS removals from their own facilities may offset their fossil emissions directly. This use would lead to an adjustment of the number of allocated allowances toward removal units.
By end-2034, the Commission is required to report to the European Parliament and Council on purchasing progress, supply and price conditions, the potential role of nature-based removals under the CRCF, and the feasibility of transitioning towards direct operator-level integration of removal units within the EU ETS.
Industrial Decarbonisation Bank
From 2028, the proposal establishes the Industrial Decarbonisation Bank as a new EU-level entity to support the scale-up and deployment of emissions reduction technologies in stationary installations covered by Annex I - the list of sectors and installations subject to the system's obligations - including those capable of generating permanent carbon removals.
In its first phase (2028–2031), an Investment Booster reserves 400 million allowances to provide fixed carbon premia on a first-come, first-served basis, with a dedicated share for lower-income Member States, strict completion deadlines, and performance guarantees through completion bonds.
From 2031, the Bank transitions to competitive bidding procedures awarding Carbon Contracts for Difference or carbon premia, providing long-term revenue stability and de-risking investment, with bid and completion bonds ensuring serious intent and timely delivery.
Better use of EU ETS revenue
The proposal sets a requirement for Member States to allocate at least 50% of ETS auction revenues to defined priority areas - including clean energy and grids, low-carbon transport, industrial decarbonization, waste management, and research and innovation. Investments incompatible with climate neutrality, including fossil fuel lock-in are explicitly prohibited. Visibility and accountability of ETS revenue use are to be strengthened through mandatory public communication of ETS-funded measures using a standardised EU label, and Member States will be required to integrate planned revenue use into their National Energy and Climate Plans (NECPs).
The Innovation Fund is updated to ensure continued and predictable support for low- and zero-carbon technologies, with strengthened implementation principles, measures against speculative applications, and enhanced transparency through annual public reporting.
The Modernisation Fund is adjusted to reflect updated eligibility and distribution indicators, expanded to cover electrification, industrial decarbonization, and CCS/CCU, while fossil fuel-based energy generation remains ineligible; Member States may also voluntarily transfer additional auction allowances to increase the Fund's resources, with an extra cap share allocated to support investments via the Industrial Decarbonisation Bank in lower-income Member States.
Sectoral expansion
The proposal also covers further sectoral expansion, in particular adds waste incineration and extends coverage within aviation and maritime transport sectors:
- Waste incineration
The proposal extends EU ETS coverage to all non-hazardous waste incineration and co-incineration installations with a capacity exceeding 3 tonnes per hour, adding a new Annex I activity. The surrender obligation will be phased in gradually from 2031 to 2034, reaching 100% of verified emissions by 2034, with temporary opt-outs available for Member States applying equivalent measures and for installations in Outermost Regions until end-2035.
Waste-to-energy for district heating is eligible for free allocation, and auction revenues may be used to support local authorities in moving up the waste hierarchy, while decarbonization technologies - notably carbon capture - are eligible for support from the Innovation Fund, Modernisation Fund, and Industrial Decarbonisation Bank.
To manage broader environmental integrity, monitoring, reporting, and verification requirements are extended to non-hazardous waste landfills, with a review clause included to assess methane emissions and the potential future extension of the EU ETS to landfilling itself.
- Aviation sector
The EU ETS currently applies only to intra-EEA flights (plus departures to the UK and Switzerland) until the start of 2027 - the so-called “stop the clock" provision – excluding emissions from most of the international flights, a limitation that was meant to encourage the development of the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA). Rather than a full extension to all departing flights as of 2027, the proposal takes a more targeted approach: the "stop the clock" on full scope extension is maintained, with a review and assessment clause in 2032 to encourage CORSIA participation, while regional scope is extended to flights landing in countries within 5,000 km of the EU from 2029 to address hub leakage and level the playing field for EU airlines. Business flights are brought into scope, the cap is increased accordingly, and the exemption for domestic flights in Outermost Regions is continued until end-2035, alongside simplification measures for reporting and access to ETS-financed decarbonization support.
Additionally, to support made-in-Europe sustainable aviation fuels (SAF), 110 million allowances are made available alongside a book-and-claim mechanism, with revenues from expanded coverage also directed towards contrail impact reduction and broader decarbonization solutions.
- Maritime sector
The proposal strengthens the maritime EU ETS through a new Sustainable Maritime Alternative Propulsion (SMAP) mechanism to recycle ETS revenues into sector decarbonisation, alongside reinforced safeguards against evasion. Scope is extended to smaller vessels between 400 and 5,000 gross tonnage to improve the level playing field, with a commensurate cap increase, while derogations for ice-class vessels and routes with structural deployment constraints are extended to end-2035.
A review clause is introduced to address potential double payments should global IMO measures come into force, reflecting the interaction between the EU ETS and developing international frameworks. Finally, a dedicated allowance reserve is established to support least developed countries and small island developing states, and a targeted allocation of allowances is provided for this purpose.
Other elements
- Feasibility of lowering the 20 MW thermal input threshold: the impact assessment concluded that such a scope expansion is unnecessary, as most relevant emissions will be covered under the upcoming EU ETS 2.
- Accounting of non-permanent carbon capture and utilisation (CCU): with the inclusion of waste incineration in the EU ETS, the majority of re-emissions from non-permanent CCU will become subject to carbon pricing. The sole exception is synthetic fuels, to address which a new activity will be added to Annex I of the ETS Directive covering the distribution points for synthetic fuels.
