EU faces backlash over slowed carbon cuts, industry windfalls

The European Commission has notably slowed the pace of emissions cap reductions under the EU ETS, proposing a linear reduction factor (LRF) adjustment from the current 4.3–4.4% down to 3.7% for 2031–35 and further to 1.7% from 2036 onward. This recalibration extends the issuance of carbon allowances well into the 2040s, rather than allowing them to expire by 2039, signaling a strategic easing of pressure on industries while still aiming to meet the 2040 climate targets.

In a bid to safeguard industrial competitiveness and prevent carbon leakage, the Commission has extended free carbon allowances for energy-intensive sectors such as steel, cement, and chemicals through 2040, a significant delay from the original phase-out timeline between 2026 and 2034. This extension aligns with a slowed Carbon Border Adjustment Mechanism (CBAM) phase-in, which now phases out free allowances by 2038 for CBAM-covered sectors, reflecting a calibrated approach to balance decarbonization ambitions with economic realities.

Crucially, the majority of these free allowances—approximately 80%—will be conditional upon companies having robust decarbonization plans in place from 2031, with the remaining 20% contingent on verified emissions reductions. This conditionality ensures that while industries receive transitional support, the financial incentives remain tightly linked to tangible investments in cleaner production, reinforcing the Commission’s principle that ETS revenues should directly fuel the green transition.

Complementing these adjustments, reforms to the Market Stability Reserve (MSR) will release more allowances earlier by lowering the buffer and halving the EUA intake rate from 24% to 12% starting in 2028. This mechanism dampens carbon prices, providing immediate relief to carbon-intensive sectors but potentially weakening the price signal that drives emissions reductions, underscoring the Commission’s delicate balancing act between maintaining industrial competitiveness and advancing climate goals.

The 2026 EU ETS reform marks a groundbreaking integration of permanent carbon removals into the compliance market by introducing a dedicated demand signal for BioCCS and DACCS certified under the EU Carbon Removal Certification Framework starting in 2031. This initiative raises the ETS emissions cap by 250 million allowances between 2031 and 2040, which will be auctioned to finance the purchase of these removals, effectively creating a €50 billion compliance market for domestic carbon dioxide removal with annual government-backed spending approaching €10 billion by 2040. Notably, the European Commission will act as the sole buyer of these certified removal units, purchasing and canceling them to avoid a direct market between emitters and providers in the initial phase, while also allowing emitters such as installations, shipping companies, and aircraft operators to offset fossil emissions with their own certified BioCCS removals, though without generating additional allowances or negative-emission credits.

Complementing domestic removals, the reform establishes a pioneering purchasing facility from 2036 to auction up to 260 million allowances for acquiring high-integrity international carbon credits aligned with Article 6 of the Paris Agreement. This mechanism aims to triple current voluntary carbon market demand over four years by directly linking international credit purchases to the EU ETS compliance framework, thereby injecting a robust demand signal into global carbon markets. However, eligibility criteria for these international credits remain under review, with a planned assessment in 2033 to ensure only high-quality, high-integrity credits are procured, reflecting the Commission's cautious approach to safeguarding environmental integrity.

The reform embeds stringent permanence and liability provisions to uphold the environmental integrity of carbon removals, mandating verifiable storage and triggering surrender obligations if stored CO2 leaks from geological sites, effectively reinstating emissions liability. While the initial focus excludes certain removal methods like biochar—sparking debate—the Commission signals potential future expansion by considering nature-based removals certified under the CRCF after 2034, contingent on their durability and verifiability. This cautious yet adaptive framework underscores the EU's commitment to credible, permanent removals while balancing market feasibility and environmental safeguards.

The European Commission’s creation of the €100 billion Industrial Decarbonisation Bank (IDB) marks a pivotal financial commitment to accelerate the green transition of energy-intensive industries. Funded through ETS revenues and structured in two phases, the IDB will initially deploy around €30 billion between 2028 and 2030, with a subsequent phase from 2031 onward dedicated to financing Carbon Contracts for Difference (CfDs) that provide crucial price stability for decarbonization investments. This strategic funding mechanism underscores the EU’s intent to blend robust financial backing with market-based instruments to catalyze industrial electrification and emissions reductions.

In a dramatic policy shift, EU member states are now mandated to channel at least 50% of their ETS auction revenues into emission-reducing projects within ETS sectors, a tenfold increase from the previous average of 5%. This enhanced spending rule ensures that auction proceeds directly fuel decarbonization efforts on the ground, reinforcing the financial ecosystem supporting the EU’s ambitious 46% electrification target for industry by 2040. By aligning fiscal flows with climate objectives, the EU is effectively tightening the feedback loop between carbon pricing and tangible emission cuts.

Complementing the IDB and spending mandates, the Innovation Fund remains a cornerstone of the EU’s financial arsenal, boasting a budget of roughly €40 billion through 2030 and covering up to 60% of eligible costs for pioneering projects in hydrogen, carbon capture, and battery technologies. This substantial backing not only de-risks cutting-edge green innovations but also signals the EU’s commitment to scaling net-zero technologies that will underpin long-term industrial sustainability. Together, these instruments create a layered financial framework designed to propel Europe’s industrial sectors toward a low-carbon future.

Industries like cement and steel underscore the critical need for a stable, transparent EU ETS framework that provides long-term investment certainty amid the capital-intensive and hard-to-abate nature of their sectors. Cement Europe stresses that this stability must be paired with a robust competitiveness agenda and an effective Carbon Border Adjustment Mechanism (CBAM) to prevent market distortions, especially given the EU's structurally higher electricity prices compared to competing regions. Meanwhile, steelmakers, represented by Eurofer, criticize the reform’s timelines as unrealistic, highlighting that affordable clean hydrogen—a linchpin for decarbonization—is not expected to be available at scale soon enough, with companies like ArcelorMittal delaying hydrogen-ready projects due to slow progress, although others like Salzgitter are advancing green hydrogen initiatives, reflecting a mixed industry readiness.

The extension of free carbon allowances to energy-intensive industries through 2038 offers a double-edged sword: while it cushions competitiveness pressures in the near term, steel industry voices warn it may dilute the urgency to invest in clean technologies now, potentially slowing decarbonization momentum. Eurofer points out that despite the extension, a sharp reduction in free allocations around 2029-2030 still looms, creating a period of uncertainty. Cement Europe opposes a slower phase-out of free allowances unless accompanied by a watertight CBAM, emphasizing the delicate balance between maintaining industrial competitiveness and driving climate ambition.

Political resistance to extending carbon pricing to road transport and heating fuels (ETS2) by a coalition of ten EU member states, including Italy and Poland, highlights the complex interplay between climate policy, social equity, and industrial competitiveness. These countries argue that a uniform carbon price disproportionately burdens lower-income households, exacerbating affordability concerns amid ongoing cost-of-living pressures. Industry groups within this coalition are lobbying for more free carbon permits without stringent conditions, while the European Commission insists on linking such relief to credible decarbonization investments, underscoring the ongoing tension between environmental integrity and political feasibility.

To sustain political legitimacy and climate credibility, EU negotiators are urged to pair carbon pricing mechanisms like ETS2 with visible fairness measures, including revenue recycling, targeted compensation, and transparent reporting on the use of funds. This approach aims to address the political fault lines exposed by member states’ pushback, ensuring that climate ambition does not come at the expense of social equity or industrial competitiveness—a balancing act that offers lessons not only for Europe but also for policymakers in regions such as Africa.