The ETS Review is Finally Here – and Europe’s Carbon Market is Entering its Next Political Test
Thomas Coutinho Lehnen Senior Account Executive, FleishmanHillard EU
After a lot of positioning and political pressure, the Commission has finally put its cards on the table. Its July review of the EU Emissions Trading System (ETS) answers some of the questions that have dominated the debate since the beginning of the year, but leaves many others firmly in the hands of Member States and the European Parliament.
Crucially, this is not a fundamental redesign of the EU’s carbon market. Instead, the Commission proposes targeted flexibilities intended to preserve the ETS as Europe’s principal carbon-pricing instrument while giving industry more time and support to deliver the transition.
At its core, the review seeks to align the ETS with Europe’s recently agreed target to reduce net greenhouse gas emissions by 90% by 2040, while enabling a more gradual decarbonisation pathway for ETS-covered sectors. That balancing act reflects the very different political environment from the 2021 Fit for 55 package. Competitiveness, energy costs, and the future of European manufacturing now sit alongside emissions reductions at the centre of the debate, with the ETS increasingly framed not only as a compliance mechanism but also as a means of supporting investment in European industrial decarbonisation. Greater flexibility does not, however, mean loosening every element of the system – in several areas it comes alongside stronger investment conditions.
The clearest example is the future supply of allowances. The Commission proposes slowing the annual reduction of the ETS cap from 3.7% in 2031-2035 to potentially 1.7% from 2036, keeping allowances in the market well into the 2040s. That slower trajectory depends partly on sufficient high-quality international carbon credits being available. Rather than allowing companies to use them directly for ETS compliance, up to 260 million allowances would finance their centralised purchase from 2036. Domestic permanent carbon removals would also enter indirectly, with revenues from additional allowances used to purchase up to 250 million tonnes of certified removals between 2031 and 2040. Both mechanisms therefore introduce new flexibility into the pathway towards 2040, while making their future operation dependent on markets and standards that are still developing.
Industry protection is another central trade-off. Free allocation would continue beyond 2030, while the phase-out for sectors covered by the Carbon Border Adjustment Mechanism (CBAM) would be slowed and its final deadline shifted from 2034 to 2038. But receiving free allowances would increasingly come with strings attached. From 2031, operators would have to establish “Invest in EU decarbonisation plans”, with European decarbonisation investment corresponding to the economic value of the free allowances received. In effect, the Commission is linking continued carbon leakage protection more closely to demonstrable investment in Europe.
That investment dimension is particularly relevant for the loan market. The Commission also proposes an Industrial Decarbonisation Bank to support the scale-up of industrial decarbonisation technologies. Its initial “Investment Booster” would use 400 million ETS allowances to provide fixed carbon premia, while from 2031 support would increasingly include carbon contracts for difference, compensating projects against movements in the carbon price. Rather than providing conventional bank lending, these public instruments are intended to address commercial risks and improve project economics, with the Commission envisaging them as helping to secure additional private financing. For lenders, their relevance therefore lies in how they may interact with the financing of capital-intensive industrial decarbonisation projects.
There is a second financial-sector angle: the credibility of the ETS itself as a long-term investment signal. Changes to allowance supply, free allocation, and the use of international credits will influence assumptions around future carbon costs and therefore the economics of investments in ETS-exposed sectors. Meanwhile, concerns voiced earlier in the year about financial intermediaries contributing to carbon-price volatility have not translated into restrictions in the Commission proposal. The Commission instead points to recent supervisory analysis that did not identify significant transparency or integrity problems in the carbon market, while strengthening annual monitoring. Whether proposals targeting financial participation resurface during parliamentary negotiations will nevertheless be worth watching.
Elsewhere, the review broadens the ETS in important areas. Municipal waste incineration would gradually enter the system from 2031, while international aviation coverage would extend from 2029 to certain flights departing from Europe and travelling within a 5,000-kilometre radius of Frankfurt. Aviation is already emerging as one of the more contentious elements, with airlines raising competitiveness concerns while environmental groups argue the Commission should have gone further. The Market Stability Reserve would meanwhile remain fundamentally quantity-based, rather than introducing carbon-price floors, preserving the principle that allowance prices should continue to be determined by the market.
The political battle is now moving from broad positioning into the details. In Council, the initial camps remain visible, but disagreements are increasingly issue-specific. France and Germany continue to favour a broadly robust ETS while questioning how the post-2036 cap trajectory should adjust if fewer international credits than expected become available. Spain, the Netherlands, and several Nordic Member States are similarly wary of weakening the system too far, while Italy and Poland continue to press more strongly on competitiveness. For the financial sector, it is notable that Italy and Poland have again raised the role of financial trading in allowance-price formation, with Italy specifically seeking an assessment of possible limits on such activity.
Parliament is also moving into a more defined negotiating phase, following the publication of lead MEP (rapporteur) Peter Liese’s draft report, from the centre-right EPP. The report broadly backs the Commission’s direction but proposes greater near-term flexibility for industry, including a 3.4% cap reduction rate for 2031-2035 followed by a steeper 2.3% rate from 2036. The report also supports the indirect use of international credits while removing the Commission’s fallback to a higher reduction rate if sufficient qualifying credits are unavailable, and proposes phasing in free-allocation conditionality more gradually. At the same time, the report would require Member States to direct 75% of ETS revenues towards decarbonisation investments, compared with the Commission’s proposed 50%. These positions leave him between S&D and the Greens, which favour stronger safeguards and remain more sceptical of international credits, and conservative groups pushing for deeper competitiveness relief. Renew is likely to remain important to any centrist landing zone as Liese seeks support across the traditional “von der Leyen majority” while keeping dialogue open with the conservative ECR.
Council and Parliament are still aiming to settle their respective negotiating positions by December, which could allow interinstitutional negotiations (trilogues) to begin in early 2027. The Commission’s broad direction therefore remains intact, but the negotiations are already showing where the pressure points will lie: how much flexibility to build into the post-2030 cap, how conditional free allocation should be, and how far competitiveness concerns can be accommodated without weakening the investment signal provided by the carbon market.
SFDR: Parliament lands its position after a difficult summer
The review of the Sustainable Finance Disclosure Regulation (SFDR) has now moved into a more decisive phase. While Parliament failed to reach an agreement before the summer recess as initially hoped, political groups ultimately converged on a compromise in early September, allowing the ECON committee to adopt its negotiating position. Council had already sealed its own mandate before the summer around the Commission’s three-category architecture of Transition, ESG Basics, and Sustainable products, meaning both institutions are now broadly aligned on the overall structure of the future regime.
The Parliament’s summer deadlock had centred primarily on the Transition category, where the EPP pushed back against stricter conditions proposed by the liberal rapporteur Gerben-Jan Gerbrandy for investments in fossil fuel-related companies. The final compromise retains an exemption from the Article 7 (Transition category) exclusions, but only where companies meet several cumulative conditions, including allocating at least 20% of capital expenditure to Taxonomy-aligned activities, having a Paris-aligned emissions reduction strategy, and investing more in Taxonomy-aligned activities than in new fossil fuel projects. This became the key landing zone allowing the rapporteur to bridge differences between the EPP and the more demanding positions of S&D and the Greens.
The final Parliament position also settles several other issues that had remained unresolved before the summer. It introduces category-specific mandatory principal adverse impact (PAI) disclosures, with requirements becoming progressively more demanding from ESG Basics to Sustainable products. On sovereign exposures, Parliament aligns closely with Council by allowing a limited share of EU general-purpose sovereign debt to contribute towards the 70% threshold for Transition products, while excluding it from the Sustainable category.
Another important area of convergence with Council is the treatment of alternative investment funds marketed only to professional investors. These would be able to opt out of the SFDR categorisation regime where retail investors have no access, provided they clearly disclose that they are not categorised under SFDR.
Where the politics leaves policy next quarter
Parliament’s mandate to enter trilogues is expected to be announced in plenary in early October, after which trilogues could still begin before the end of the year. The key question will be how the two sides reconcile remaining differences around Transition-category exclusions, product-level disclosures, and the treatment of sovereign exposures within the now broadly settled three-category architecture.
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