The European Union Emissions Trading System (EU ETS) remains a cornerstone of Europe’s climate policy, representing the world’s first and largest carbon market. Established in 2005, its fundamental principle is “cap and trade,” whereby a limit, or cap, is imposed on the total amount of greenhouse gas (GHG) emissions permitted from covered installations. Within this cap, emission allowances (EUAs) are created, with each allowance entitling the holder to emit one tonne of CO₂ equivalent. These allowances are primarily sold via auctions, although a portion has historically been allocated free of charge to certain industries. Companies are required to monitor and report their emissions annually and surrender a corresponding number of allowances, facing substantial fines for non-compliance.

This system has proven effective, contributing to an estimated 47% reduction in emissions from European power and industrial plants by 2023, compared to 2005 levels. Additionally, the EU ETS has generated significant revenue, exceeding €175 billion since 2013, with Member States now committed to reinvesting these funds entirely into climate action and a just transition.

Key Legislative Reforms and Rising Ambition

Recent legislative reforms, particularly those finalised in the 2023 revision of the ETS Directive, indicate a marked increase in the system’s ambition and scope. A principal change is the tightening of the emissions cap, targeting a 62% reduction by 2030 relative to 2005 levels. This more aggressive target is supported by an annual reduction factor of 4.3% between 2024 and 2027, rising to 4.4% from 2028 onwards. The ongoing tightening of the cap ensures a long-term scarcity of allowances, preserving market value and reinforcing the economic incentive for businesses to reduce emissions in a cost-effective manner.

Expansion into Maritime Transport and Broader Sectoral Reach

Beyond the reduced cap, the EU ETS has broadened its sectoral coverage. From 2024, emissions from maritime transport will be included, meaning that large vessels (5,000 gross tonnage and above) entering EU ports will now fall under the scheme. The inclusion will be phased in: 40% of 2024 emissions to be surrendered by September 2025, 70% of 2025 emissions by September 2026, and 100% from 2026 onwards by September 2027. This expansion extends the “polluter pays” principle to a wider range of economic sectors, transforming the EU ETS from an industrial compliance mechanism to a broader societal carbon pricing framework.

For businesses in newly covered sectors such as logistics and shipping, this change introduces unfamiliar compliance burdens, requiring the development of fresh strategies for emissions tracking and allowance procurement.

Phase-Out of Free Allowances and Rising Carbon Costs

Another significant reform is the gradual reduction, and eventual elimination, of free allocation of allowances to companies. This reduction aligns with the tighter cap and is contingent on demonstrable decarbonisation efforts. For example, free allocation in the aviation sector will be completely phased out by 2026. Energy-intensive industries that previously benefited from free allowances will now be exposed to substantially higher carbon costs. For median companies, projections indicate a potential increase of between 2.5-fold and more than twentyfold in carbon-related expenditures by 2030.

This shift removes the “perverse incentive” whereby free allowances could become a source of profit, instead directly linking emissions to cost. As a result, businesses are increasingly compelled to invest in green technologies to reduce carbon intensity. This regulatory structure, in combination with the tightening cap, aims to exert sustained upward pressure on carbon prices, making decarbonisation a more economically rational strategy than reliance on purchasing allowances. Firms that delay action will encounter exponentially increasing costs, positioning carbon management as a key competitive differentiator.

ETS2: A New Carbon Pricing Regime for Buildings and Transport

A new emissions trading system, referred to as ETS2, is scheduled to launch in 2027. It will cover emissions from buildings, road transport, and other sectors, thereby expanding the reach of carbon pricing. By 2027, it is projected that 78% of total greenhouse gas emissions from the European Economic Area (EEA) will be covered.

Carbon prices under ETS2 could rise significantly, potentially reaching €149 per metric tonne by 2030. If fully passed through, this would result in increases of 22–27% in road transport costs and 31–41% in residential heating expenses. These consumer-facing impacts are likely to generate broader societal repercussions and potential political resistance, as seen in responses from EU Member States such as Poland, the Czech Republic, and Slovakia.

To address these challenges, the Social Climate Fund (SCF) has been created, mobilising €86.7 billion from ETS2 revenues to support vulnerable households during the green transition.

Market Stability Reserve (MSR): Controlling Allowance Supply

The Market Stability Reserve (MSR) has also been updated to ensure equilibrium in the evolving carbon market. This mechanism removes allowances from circulation if the surplus exceeds specified thresholds (e.g., 24% of total allowances if in excess of 833 million), or reintroduces them if scarcity arises. In 2024, with just 400 million allowances in circulation, over 2.8 billion were invalidated across two years, highlighting the MSR’s active role in balancing supply.

Strategic Implications for Businesses

These regulatory developments carry profound strategic implications for European enterprises. Increased compliance obligations and financial exposure necessitate a proactive stance towards carbon cost management. At the same time, higher carbon prices and diminishing free allocations present powerful incentives for firms to invest in energy efficiency, low-carbon technologies, and sustainable production processes.

EU ETS revenues are being directed into initiatives such as the Innovation Fund, Modernisation Fund, and REPowerEU, designed to accelerate green investment. As a result, the EU ETS is evolving from a punitive taxation model into a broader industrial strategy that fosters energy sovereignty, supports European clean technology companies, and reduces geopolitical energy dependencies.

CBAM: Safeguarding European Industry

The Carbon Border Adjustment Mechanism (CBAM) complements the EU ETS by imposing a carbon cost on imported goods, based on the emissions embedded in their production. This mechanism protects EU industries from unfair international competition and re-establishes a level playing field. It represents a paradigm shift where carbon intensity, much like labour intensity during industrialisation, becomes a defining factor of global competitiveness.

To comply, businesses must ensure accurate emissions monitoring and verification by accredited auditors and surrender the requisite allowances by 30th September each year.

AFS Energy: Supporting Businesses through the Transition

AFS Energy plays a vital role in helping businesses navigate this complex landscape. The company offers expert guidance on market trends, regulatory changes, and best practices for carbon compliance. Its trading platform enables efficient EUA procurement with real-time pricing insights, risk mitigation tools, and strategic planning services, including hedging strategies and automated regulatory alerts.

Through this support, AFS Energy enables clients to forecast and manage their carbon budgets, linking production scenarios with EUA costs, and empowering data-driven investment in decarbonisation. With increasing price volatility and market complexity, managing carbon is becoming a financial discipline as much as a compliance necessity. AFS Energy’s expertise in environmental markets and financial services makes it uniquely positioned to support this transition.

A Strategic Imperative for European Industry

The EU ETS is undergoing a fundamental transformation, becoming more ambitious, expansive, and economically impactful. A passive approach will result in escalating CO₂ costs. Consequently, proactive planning and strategic investment in emissions reduction are not only compliance measures but crucial steps for maintaining competitiveness and resilience in Europe’s evolving industrial landscape.