More Flexibility Is Not Always Better: The ETS Reform Must Not Undermine the Price Signal

Tomorrow, the EU Commission will table its proposals for a reform of the existing European Emissions Trading System. This marks the starting point of the actual political negotiations about the future of Europe’s most important climate action instrument. The deliberations of the Council and the Parliament and the subsequent trilogues will not only focus on technical details, but more specifically on the very core of Europe’s post-2030 industrial and climate policy: How can climate policy be consistently implemented without placing an excessive burden on businesses?

The conflict will follow familiar lines. Industrial companies are calling for relief from CO₂ and energy costs, while climate policymakers are insisting on compliance with European climate targets. But things are more complex than that. The key criterion to be considered in the negotiations now getting under way is a different one: Will the reform lead companies to invest more heavily in climate-neutral technologies now – or will it mainly create the expectation that policymakers are continuing to water down the emissions trading scheme?

The last reform in 2023 set the EU emissions trading scheme on a very ambitious path. Under the current legislation, the number of new allowances will significantly decline in the long term. For many industrial plants, this effectively means that they will come under increasing cost pressure unless they decarbonise their processes. It is precisely this scarcity of allowances that lies at the heart of the scheme. It ensures that businesses factor future CO₂ costs into their investment decisions today. This approach – using a CO₂ price to take the negative effects of emissions into account when making investment decisions – is efficient. By contrast, policy instruments such as subsidies for climate-neutral technologies or emission bans result in significantly higher costs. Consequently, the Commission’s proposal must have its effectiveness be judged on whether it stabilises this price-based investment logic.

At the same time, the ramp-up in investment in energy-intensive industries clearly falls short of what would be required to follow this path. This is not solely due to the price of CO₂; companies are also reluctant to invest because of the lack of hydrogen and CCS infrastructure, electricity grids, permits and stable business models. A higher CO₂ price alone will not be sufficient to automatically resolve these bottlenecks. Unless complementary measures are taken, what is intended as an investment signal can turn into cost pressures that are politically untenable. The reform must therefore provide some scope for flexibility.

Adjusting the Market Stability Reserve may be sensible if it dampens excessive price and liquidity fluctuations without calling into question the long-term scarcity of the system. A structured approach to residual emissions – that is, emissions that are unavoidable or can only be avoided at very high cost – is economically plausible. Temporary free allocations of allowances are justifiable, at least as long as the carbon border adjustment mechanism does not apply to exports. However, it would be wrong to confuse flexibility with relief without any quid pro quo. If companies learn that politicians will continue to water down emissions trading in the face of resistance, it will be worth their while to sit tight. This would not only drive down the price of CO₂; it would also undermine the credibility of future climate policy.

The focus on green conditionality set out in the Commission’s proposal points in this direction. Companies that receive free allowances or are reimbursed from ETS revenues must demonstrably invest in decarbonisation in Europe. Free allocations are a compensation for the higher CO₂ costs incurred by exporting companies that are exposed to competition in third countries from firms not subject to climate levies. However, free allocation carries the risk of distorting competition within the EU and of investment projects being postponed. It is therefore reasonable to link these allocations to conditions relating to the transition. Those who have already invested in green technologies must not

be placed at a disadvantage retrospectively. Those who could invest but are banking on a future relaxation of policy should not be rewarded. And those who use free allowances to keep old plants running for as long as possible or to finance investments outside Europe undermine the legitimacy of the system. Conditionality is therefore not a bureaucratic add-on, but it is a key test of whether relief actually brings about transformation.

The use of public funds should also be economically justified. The ETS generates substantial revenue; however, it does not automatically follow that these funds should be earmarked for industry. Strict earmarking can be problematic from a budgetary perspective and distort spending. What is crucial, rather, is whether public funds are deployed where private investment fails despite the CO₂ price, due to clearly identifiable market barriers. Identifying such barriers is inherently difficult, but the effort could be justified, particularly in relation to hydrogen and CO₂ infrastructure, grid connections, climate protection contracts and coordination within industrial clusters for key green technologies. Although general compensation reduces costs in the short term, it does not remove barriers to investment.

Permanent CO₂ removals may play a role in addressing residual emissions after 2039. As it is currently assumed that these removals will be costly, their integration makes sense only for hard-to-abate residual emissions. Since there are foreseeable uncertainties regarding the actual and permanently verifiable climate impact of permanent removals, they should initially be limited and integrated into the ETS subject to stringent requirements regarding permanence, additionality and monitoring. It is crucial that their use does not crowd out investment in available abatement technologies.

International emission credits can play a complementary role if they credibly finance additional reductions in third countries and support reciprocal climate protection efforts by those countries. For the EU ETS itself, however, direct crediting would be risky as long as quality, additionality and quantity limits are not clearly guaranteed. It therefore makes economic sense to allow international credits to be counted towards the overarching EU climate target, but only to a limited extent, while keeping them outside the ETS for the time being. This ensures that scarcity in the allowance market remains visible, and international cooperation under Article 6 can be developed separately.

There is no benefit to the EU in a weaker emissions trading system which, while reducing political pressure in the short term, would weaken investment incentives in the long term. What the EU needs is a more credible emissions trading system: with a reliable supply of allowances, an effective price signal and targeted support where market barriers are hindering investment. The reform should not politically water down the CO₂ price. Instead, it should ensure that the price provides a viable and sustainable framework for investment.