The EU Is Strengthening Its Emissions Trading System: A New Era for Carbon Markets

The European Union‘s Emissions Trading System (EU ETS), the cornerstone of the bloc’s climate policy, is undergoing a fundamental transformation in 2026. With tightened technical parameters, the full activation of the Carbon Border Adjustment Mechanism (CBAM), and a fresh reform proposal targeting market stability, the EU’s carbon pricing architecture has entered a decisive new phase.

What Is the EU ETS and How Does It Work?

The EU ETS operates as a cap-and-trade system, where companies are required to purchase permits to cover their carbon emissions. The total number of permits is capped, and this cap gradually declines over time, ensuring that emissions are reduced in line with the EU’s climate targets. Since its launch in 2005, the ETS has become a central pillar of Europe’s climate strategy, covering approximately 10,000 power plants and industrial facilities.

The system is now in its fourth trading phase, covering 2021 to 2030. The legislative framework is spelled out in the ETS Directive, which has been revised multiple times to align with the EU’s overarching climate targets.

Tighter Caps, Faster Reductions

Under the Fit for 55 reform package, the EU ETS now targets a 62% reduction in emissions by 2030 compared to 2005 levels, a significant increase from the previous 43% target. The annual reduction rate of the cap has also been accelerated to 4.3% per year from 2024 to 2027, rising to 4.4% from 2028 to 2030.

In addition, the EU-wide quantity of allowances was reduced by 90 million tonnes of CO₂ equivalent in 2024 and by a further 27 million tonnes in 2026. This supply squeeze is designed to push carbon prices upward, prodding companies to invest in cleaner production technologies rather than simply buying permits.

Free Allowances Being Phased Out

The progressive phase-out of free allowances for the aviation sector was completed between 2024 and 2026, and free allowances for sectors covered by the Carbon Border Adjustment Mechanism, including steel, cement, aluminium, fertilisers, and hydrogen, are being wound down between 2026 and 2034.

From 2026 to 2034, the free allowances granted to EU manufacturers will fade on a progressive curve, consequently increasing the cost of manufacturing for businesses if their processes remain unchanged.

This is not a punitive measure but a market-design choice: by raising the cost of inaction, the system incentivises green investment without mandating specific technologies.

Expanding Scope: Shipping, Methane and New Sectors

January 2026 marked a turning point for maritime transport under the EU ETS. After a two-year phase-in, shipping companies now face full compliance obligations. From 2026, methane (CH₄) and nitrous oxide (N₂O) emissions from maritime transport are also included in the system alongside CO₂.

In 2024, the system generated €38.8 billion in revenues, bringing total revenues since inception to over €250 billion. These funds are primarily distributed to Member States to support climate action, clean energy deployment and innovation.

A new emissions trading system, called ETS2, has been created to cover emissions from buildings, road transport and additional sectors. The new system will become operational in 2027.

CBAM: The Carbon Border Tax Goes Live

The most consequential external manifestation of the ETS overhaul is the CBAM entering its full implementation phase on 1 January 2026.

CBAM is a mechanism that targets the carbon intensity of goods exported to the EU, effectively extending EU carbon pricing to imported products. It currently covers electricity, iron and steel, cement, aluminium, fertilisers and hydrogen.

To ease the burden on smaller operators, companies importing less than 50 tonnes of CBAM-covered goods per year, or goods containing fewer than 100 tonnes of embedded carbon emissions annually, are exempt from the mechanism.

The Market Stability Reserve Reform: The April 2026 Proposal

On 1 April 2026, the European Commission announced a first concrete measure to reinforce the EU ETS by proposing an amendment to the Market Stability Reserve (MSR). Under the current system, all allowances held in the reserve above 400 million are invalidated. The proposed amendment stops this automatic invalidation mechanism, allowing these allowances to be retained as a strategic buffer that can support market stability.

The proposal follows a commitment made by Commission President Ursula von der Leyen at the March European Council, where she pledged to introduce near-term measures to revise the ETS amid pressure from member states concerned about industrial competitiveness. A comprehensive review of the EU ETS is planned for July 2026.

The EU ETS has been a key driver of decarbonisation: EU domestic emissions dropped by 39% while the economy grew by 71% between 1990 and 2024.

Political Tensions: Suspend or Reform?

The system’s strengthening comes against a backdrop of growing political friction. As Europe has faced rising energy prices, first driven by the Russia-Ukraine war, several member states have called on the Commission to review the ETS to help reduce pressure on industry. Italy and others have pushed for a suspension of the system pending a comprehensive overhaul.

The reform represents a balancing act, maintaining the system’s environmental effectiveness while ensuring it remains economically sustainable and politically viable. It highlights how climate policy is increasingly being shaped by a combination of environmental goals, market realities and geopolitical pressures.

The current proposal is only the initial phase of a broader review, with more comprehensive reforms expected later in 2026. These are likely to address deeper structural aspects of the system, including its long-term trajectory. One potential outcome could be the extension of the ETS timeline beyond its current endpoint of 2039.

The Social Climate Fund: Sharing the Costs of Transition

More resources have been mobilised to support people and businesses in the green transition. Member States have committed to using all EU ETS revenues, or their financial equivalent, towards climate action and a just, green transition. The Innovation Fund and Modernisation Fund budgets have been increased accordingly.

A Social Climate Fund will be established to support vulnerable households, micro-enterprises and transport users affected by the price impacts of the new ETS2 system. The fund is expected to reach approximately €87 billion, financed through ETS auction revenues supplemented by national contributions.

What This Means Beyond Europe

The EU ETS reform does not stop at European borders. CBAM is among the most internationally significant components of the Fit for 55 package. Its purpose is to prevent carbon leakage, the risk that EU producers, facing higher carbon costs, would be undercut by competitors in countries with less stringent climate regulation.

Countries that have developed their own carbon pricing mechanisms stand to benefit: costs already paid domestically can be deducted from CBAM charges. Those that have not are facing growing trade exposure as the mechanism matures.

The EU ETS overhaul signals something larger than a regulatory update: it places carbon pricing at the intersection of trade, industrial and geopolitical policy. The system that began in 2005 as an environmental experiment is now one of the most consequential instruments shaping global competitiveness. For businesses and governments alike, adapting early is no longer optional, it is a competitive imperative.