The proposed changes to the carbon pricing policy intend to balance industrial competitiveness with climate goals.

By Michael D. Green and James Bee

On 17 July 2026, the European Commission (Commission) presented its review of the EU Emissions Trading System (EU ETS), alongside an Electrification Action Plan. The EU ETS is the EU’s flagship carbon pricing mechanism, under which businesses in select industries must surrender and/or pay for allowances for each tonne of carbon they emit, creating a financial incentive to reduce greenhouse gases (GHG). The scheme covers around 40% of total EU GHG emissions and has led to emissions reduction in ETS sectors of approximately 50% since its establishment in 2005.

In this blog post, we cover selected elements of the EU ETS review. For background information on the EU ETS and recent measures intended to modernise and increase the flexibility of the system, refer to this Latham blog post.

Key Elements of the Review

The key proposed changes to the EU ETS framework are set out below:

Extended Allowance Timeline

The review intends to align the EU ETS with the EU’s 2040 emission reduction target of a 90% reduction in GHG emissions relative to 1990 baseline levels by adjusting the EU ETS reduction trajectory for 2031-2035 and 2036-2040. This change would allow a slower annual decline in the total number of allowances, through a reduction in the linear reduction factor (LRF) from 2036, and permit the continued issuance of allowances into the 2040s.

The LRF is the fixed annual rate at which the total emissions cap under the EU ETS decreases, thereby dictating the pace at which the total supply of emission allowances is reduced. Between 2013 and 2020, the LRF was 1.74% per annum, and has increased to the current rate of 4.3%. The proposal updates the LRF to 3.7% for 2031–2035 and 1.7% for 2036–2040, making the trajectory more gradual and intended to align with the level of domestic climate ambition.

International Carbon Credits

The EU’s 2040 emissions reduction goal allows high-quality international carbon credits to contribute to the overall 90% emissions reduction goal (relative to 1990 levels) from 2036 onward, as part of the EU’s pathway to carbon neutrality by 2050. The specific use of such credits will be subject to an impact assessment and EU law on integrity criteria and operationalised through the reduced LRF (as discussed above).

Free Allocations

Under the current EU ETS, certain energy-intensive industries (such as steel, cement, or chemicals) receive a free portion of allowances required to comply with the EU ETS, as they are considered specifically exposed to carbon leakage. The proposal extends these support measures until 2040, rather than the current 2030 cut-off. Earlier this month, a separate proposal on EU ETS heat and fuel benchmarks was also adopted, which is expected to increase free allocations to industry by €6 billion over the 2026–2030 period.

From the five-year period starting on 1 January 2031, the proposal would condition all free allocations for operators on their submission and implementation of an independently verified plan to invest in EU decarbonisation. This builds on the existing approach already used for district heating. Under the proposal, 80% of the free allowances would be allocated annually once the plan is approved; the remaining 20% would be allocated once the implementation and resulting significant emissions reductions are verified at period-end.

Finally, as the EU Carbon Border Adjustment Mechanism (EU CBAM) is phased in, free allocations for EU CBAM-covered sectors are being phased out. The proposal slows this phase-out (and therefore the speed of the phase-in of CBAM) by reintroducing 15% of the free allocation that would otherwise have been removed, starting in 2028, with the full phase-out being completed by 2038.

Carbon Removals

The review proposes to integrate domestic carbon removals into the EU ETS, with safeguards in place. Specifically, the review proposes to integrate permanent carbon removals — biogenic carbon capture and storage (BioCCS) and direct air carbon capture and storage (DACCS) — into the EU ETS by increasing the cap by 250 million allowances, which will be made available to the Commission to auction from 2031 to 2040 to generate revenues for the purchase of an equivalent amount of removal units.

This increase corresponds to the EU Carbon Removal Certification Framework (EU CRCF) removal units that the Commission is mandated to purchase. The EU CRCF is the EU’s voluntary framework for certifying carbon removals, covering several categories of removal and carbon farming activities. Here, the relevant part of the EU CRCF is “permanent” carbon removals (including BioCCS and DACCS), where carbon is captured and stored for a significant period, typically covering a timescale of centuries. The CRCF certification would provide the legal basis for verifying the removal units that the Commission proposes to purchase under the EU ETS. For more information on the EU CRCF, refer to this Latham blog post.

Industrial Decarbonisation Bank and ETS Revenues

The proposal establishes an Industrial Decarbonisation Bank, which would deploy €100 billion in funding to support decarbonisation projects. An ETS Investment Booster would be available before 2030 as the Bank’s “first phase” and would involve rewarding early investors in decarbonisation. Member States would also be required to spend 50% of their national ETS revenues on investments to decarbonise ETS sectors.

Market Stability Reserve Reforms

The proposal introduces significant reforms to the Market Stability Reserve (MSR) to address concerns about market liquidity. The MSR is a mechanism designed to address imbalances between supply and demand for EU ETS allowances, by adjusting the volume of allowances in circulation. The proposal intends to make the parameters of the MSR — the upper and lower thresholds, and the release amount — more dynamic over time.

The proposal also introduces a new “lower buffer” mechanism for more proportionate releases of allowances. These changes are intended to ensure gradual carbon price development and prevent excessive volatility.

Additional Measures

Further significant elements of the review include:

• the inclusion of municipal waste incineration in the EU ETS from 2031;
• the extension of the Innovation Fund to support low-carbon innovation and clean tech competitiveness;
• updates to the Modernisation Fund to support energy system modernisation in lower-income Member States;
• the expansion of aviation coverage;
• enhanced maritime transport provisions; and
• downstream accounting for carbon capture and utilisation in products, enabling a decarbonisation route for hard-to-abate sectors.

Next Steps

As next steps, the European Parliament and European Council will finalise their positions, expected before the end of 2026, ahead of inter-institutional negotiations planned for January 2027.

The review forms the first part of a broader package of measures to achieve the 2040 climate ambition. The Commission aims to keep the EU on track for its 2050 climate neutrality goal while balancing industry competitiveness concerns.

This article was prepared with the assistance of Samantha Banfield and James Thompson at Latham & Watkins.

Latham & Watkins will continue to monitor developments relating to the EU ETS and the broader European climate regulatory landscape.