What’s at stake for Europe’s carbon market blueprint?

Commission proposes slower carbon cap reduction through 2036

The European Commission tabled a formal proposal on July 17, 2026 to revise the EU Emissions Trading System. The revision slows the annual decline of the carbon cap. It also extends free carbon permits for heavy industry until 2038. These changes mark a shift from accelerating decarbonisation to managing economic and political pressures.

The proposal targets the EU’s 2040 climate objective rather than the stricter 2030 goal. That 2040 target requires an 85% domestic emissions reduction by 2040. Consequently, the revision alters the carbon market’s core structure for pricing pollution. The changes affect how quickly industries must cut emissions and what support they receive during the transition.

Businesses that rely on the EU ETS for compliance planning now face a different timeline. The slower reduction creates more gradual pressure on emissions. However, it also introduces new uncertainties around carbon pricing and competitiveness.

Linear reduction factor drops to 1.7% by 2036

The linear reduction factor determines how fast the carbon cap shrinks each year. Under current rules, the factor stands at 4.3% between 2024 and 2027, then rises to 4.4% from 2028 to 2030. The Commission proposes reducing this to 3.7% by 2031 and further to 1.7% by 2036. This substantially slows the rate at which companies must cut emissions.

Meanwhile, free permits for heavy industry receive an extension. Steel and cement sectors currently see free allowances phased out by 2034. The proposal pushes that deadline to 2038. Aviation’s free permit phaseout remains on track for 2026. The extension for heavy industry comes with conditions tied to decarbonisation plans.

The Market Stability Reserve also undergoes significant changes. This mechanism manages the surplus of carbon allowances in the market. Currently, it takes in 24% of excess allowances and invalidates permits when the surplus exceeds 400 million. The proposal cuts the intake rate to 12%. It also stops the invalidation mechanism entirely. This keeps excess allowances available as a buffer rather than removing them from circulation.

Revenue allocation rules shift too. Member states currently spend EU ETS revenues on climate initiatives without a minimum percentage requirement. The new rules mandate that at least 50% of revenues fund domestic industries. In addition, 400 million permits worth approximately €30 billion will serve as an investment fund for clean technology.

Context from the 2023 Fit for 55 reforms

The EU ETS is the world’s largest carbon market. It has covered power plants, factories, and aviation since 2005. The 2023 Fit for 55 reforms strengthened the system considerably. They raised the 2030 emissions reduction target to 62% compared to 2005 levels. They also introduced the Carbon Border Adjustment Mechanism to prevent carbon leakage.

Carbon leakage occurs when businesses move production to countries with weaker climate rules. CBAM addresses this by imposing carbon costs on imports from those countries. Therefore, EU manufacturers face less competitive disadvantage from stronger domestic climate policies.

The 2026 proposal reverses some of that acceleration. By lowering the linear reduction factor and extending free permits, it reduces carbon price pressure on industries. President von der Leyen called for preserving market stability in March 2026. This followed concerns about industrial competitiveness and energy costs across member states.

The timing reflects political realities. Industries facing high energy costs and global competition have pressed for relief. Finance ministries worry about the economic impact of rapid decarbonisation. Environmental groups, conversely, argue the pace must increase to meet climate commitments. The proposal attempts to balance these competing pressures.

Municipal waste incineration enters the system from 2031

The ETS will gradually expand to cover municipal waste incineration between 2031 and 2034. Countries can delay inclusion until 2035 if they meet specific recycling targets or maintain a carbon tax. This extension brings additional emissions sources under carbon pricing. However, it also creates administrative complexity for local authorities managing waste facilities.

A substantial portion of permits will support specific objectives. By 2030, 400 million permits valued at €30 billion will be reserved for clean technology investment. Another 280 million permits will fund clean energy projects in the poorest member states. This redistribution aims to ensure the transition does not disadvantage less wealthy regions.

The proposal sets clear timelines for implementation. Between 2026 and 2034, free allowances phase out gradually for most sectors. Steel and cement now receive an extension to 2038. From 2031 to 2036, the reduced linear reduction factor takes effect. These dates create planning windows for businesses but also compress the timeline for deeper emissions cuts later.

UK businesses face indirect effects through supply chains

UK companies operating in EU markets must understand these changes. Although the UK left the EU ETS, many British businesses sell to European customers or operate facilities in member states. Supply chain partners in the EU will experience different carbon cost trajectories. This affects pricing, competitiveness, and contract negotiations.

Exporters to the EU also need to monitor CBAM developments. The border adjustment mechanism applies carbon costs to imports. As the EU ETS rules change, CBAM calculations may shift too. British manufacturers exporting steel, cement, or other covered products should track these adjustments closely.

Furthermore, the extension of free permits to 2038 creates a competitive dynamic. EU heavy industry receives more support for longer. UK competitors without equivalent support may face disadvantages in European tenders. This matters particularly for construction, infrastructure, and manufacturing supply chains.

Service providers supporting EU clients must also adapt. Consultancies helping European businesses with carbon reporting will need to update their guidance. Software firms providing emissions tracking tools must adjust their systems. Training providers should revise their materials to reflect the new timelines and requirements.

Carbon price volatility increases under new reserve rules

Halving the Market Stability Reserve intake rate carries risk. The mechanism currently removes excess allowances from the market to maintain price stability. Reducing the intake from 24% to 12% means more allowances remain in circulation. Stopping the invalidation mechanism compounds this effect.

Consequently, supply volatility may increase. If demand surges unexpectedly, prices could spike sharply. Businesses relying on stable carbon costs for budget planning face greater uncertainty. Hedging strategies may become more expensive or complex. Financial institutions trading in carbon markets will need to reassess their risk models.

The slower reduction factor also affects long-term price expectations. Fewer permits must be removed from the market each year. This creates more supply relative to the original trajectory. However, the 2040 target remains ambitious at 85% reduction. The gap between the gradual cuts through 2036 and the steep reductions needed after creates a cliff edge.

Industries planning capital investments must consider this timing carefully. Equipment installed in the next decade will still operate when sharper cuts begin. Therefore, businesses cannot simply delay decarbonisation until later. The economics of low-carbon technology still favour early adoption for assets with long lifespans.

Revenue mandate shifts funds from broad climate action to industry support

Requiring member states to spend at least 50% of ETS revenues on domestic industries redirects substantial funds. Previously, countries could allocate revenues across various climate initiatives. The new rule narrows that flexibility. Finance ministries may resist this mandate because it constrains budget decisions.

The shift also changes the nature of climate finance. Broader climate projects include public transport, building efficiency, and nature restoration. Industrial support focuses on specific sectors like steel and cement. This concentration may accelerate decarbonisation in heavy industry. However, it could slow progress in other areas that previously received ETS funding.

For businesses outside heavy industry, this matters. Grants for energy efficiency upgrades or renewable energy installations may become scarcer. Public sector procurement budgets for green infrastructure could tighten. Companies planning projects that depend on climate finance should diversify their funding sources.

The €30 billion clean technology investment fund offers opportunities. Manufacturers developing low-carbon industrial processes may access support. However, competition for these funds will be intense. Businesses should prepare strong applications that demonstrate credible decarbonisation pathways and commercial viability.

What UK SMEs should know about the ETS revision

The Commission’s proposal slows annual emissions reductions through the linear reduction factor changes. By 2031, the factor drops to 3.7%, then to 1.7% by 2036. This compares to 4.3% currently and 4.4% planned for 2028 to 2030. The slower pace reduces immediate pressure on industries to cut emissions.

Free carbon permits for steel and cement industries now continue until 2038 instead of ending in 2034. This extension provides longer transition support for heavy industry. However, recipients must demonstrate credible decarbonisation plans to maintain access to free allowances.

The Market Stability Reserve intake rate falls from 24% to 12%. The mechanism will also stop invalidating excess allowances above 400 million. These changes keep more permits in circulation as a buffer. However, they may increase price volatility if demand shifts unexpectedly.

Member states must allocate at least 50% of EU ETS revenues to domestic industry support. Additionally, 400 million permits worth approximately €30 billion will fund clean technology investments by 2030. Another 280 million permits will support clean energy in less wealthy member states.

Municipal waste incineration enters the EU ETS between 2031 and 2034. Countries meeting recycling targets or maintaining a carbon tax can delay inclusion until 2035. This expands the scope of emissions covered by carbon pricing.

The proposal targets the 2040 climate goal of 85% emissions reduction rather than accelerating towards the 2030 target. This represents a strategic shift from rapid decarbonisation to managed economic transition. The European Parliament and Council must now review and potentially amend the proposal before it becomes law.

Balancing competitiveness against climate ambition creates strategic tensions

The proposal prioritises industrial competitiveness over the pace of emissions reductions. Extending free permits and slowing the linear reduction factor explicitly acknowledges economic pressures. Industries facing high energy costs and global competition receive more gradual carbon pricing. This may protect jobs and prevent facility closures in the short term.

However, the slower pace creates challenges for meeting long-term targets. The 2040 goal requires 85% emissions reduction. The gap between gradual cuts through 2036 and the steep reductions needed after 2036 tightens considerably. Businesses delaying investment in low-carbon technology may face sudden cost increases when sharper cuts resume.

The EU ETS serves as a global model for carbon pricing. Weakening its core mechanism sends signals to other countries developing similar systems. If the EU reduces climate ambition for economic reasons, other nations may follow. This could slow the global transition to net zero and undermine international climate cooperation.

For UK businesses, the implications extend beyond direct compliance. Supply chain partners in the EU will operate under different incentives. Procurement criteria in European tenders may shift. Companies exporting to EU markets or sourcing from European suppliers should monitor these developments closely. Our sustainable procurement guidance helps businesses navigate these evolving requirements.

The proposal also affects carbon accounting practices. Businesses reporting Scope 3 emissions must understand how supplier emissions change under the new rules. Those pursuing net-zero targets need to reassess their decarbonisation pathways. The carbon reporting support we provide addresses these challenges for UK SMEs working with European partners.

Parliament and Council negotiations will shape final rules

The Commission’s proposal begins a legislative process involving the European Parliament and Council. Both institutions must approve the revision before it takes effect. Finance ministries in member states may resist the 50% revenue mandate. They typically prefer budget flexibility over earmarked spending requirements.

Environmental committees in Parliament will likely challenge the reduced linear reduction factor. They may argue it contradicts the EU’s climate commitments under the Paris Agreement. Some members may push for steeper cuts or shorter extensions of free permits. Industrial committees, conversely, may support the competitiveness measures or seek additional protections.

The negotiation process typically takes 12 to 18 months. During this period, businesses face uncertainty about final rules. Planning assumptions must account for potential amendments. Companies should develop scenarios based on different legislative outcomes rather than assuming the proposal passes unchanged.

Stakeholder consultation will continue throughout the process. Industry associations, environmental groups, and member state governments will all seek to influence the final text. UK businesses with European operations or customers should consider whether to engage through relevant trade bodies or directly with EU institutions.

Further information from official sources

The European Commission’s climate action portal provides detailed information about the EU ETS and ongoing revisions. The site includes policy documents, technical annexes, and impact assessments.

The European Parliament’s press room publishes updates on legislative progress as the proposal moves through committee reviews and plenary votes. This helps businesses track potential amendments and timing.

For UK businesses considering how these changes affect carbon reporting obligations, the government’s guidance on measuring and reporting environmental impacts remains relevant. While UK and EU systems differ, many reporting principles overlap.

Companies developing decarbonisation strategies should consult the UK government’s net zero strategy to understand domestic policy direction. This helps align European compliance requirements with UK market expectations and regulatory trends.