In its latest review of the EU Emissions Trading System ("ETS"), the European Commission proposes to slow the rate at which the ETS emissions cap shrinks and allow for more free allowances. The latest proposal also intends to increase investments in the EU's energy system to improve competitiveness, solidifying the position of the EU ETS as a key financing mechanism for the energy transition. The direction of this file will now be set by the co-legislators, the European Parliament and the Council. Key points for the institutions will include the linear reduction factor ("LRF"), free allocation conditionality, and the aviation, maritime and waste incineration scope extensions.
The definitive regime of the EU Carbon Border Adjustment Mechanism ("CBAM") has applied since 1 January 2026, but the regulatory framework remains under development. A proposal that was issued on 17 December 2025 is moving through the EU's legislative procedure. It would extend the CBAM's scope beyond the current basic materials to selected downstream goods and introduce anti-circumvention measures. Meanwhile, the European Commission continues to adopt implementing and delegated acts operationalising the definitive regime.
1. EU ETS
On 17 July 2026, the European Commission presented the latest review (the "Review") of the EU ETS.1 The Review is the principal reform initiative discussed below, but it is being pursued alongside separate, targeted ETS measures at different stages of the legislative process, including changes to free allocation under the heat and fuel benchmarks and amendments to the market stability reserves for the existing ETS and ETS2.2 Key components of the legislative proposal include:
- Wider scope. The EU ETS coverage would be extended to further aviation routes and to smaller shipping vessels (down to 400 gross tonnage), and municipal waste incineration is gradually brought into the ETS from 2031.
- Allowances will phase out more gradually. The LRF is set to fall to 3.7% for 2031–2035 and 1.7% for 2036–2040 (subject to the use of international credits, see below), down from the current rate of 4.3% (applicable for 2024–2027, itself an increase from 2.2% from 2021 and 1.74% before that), giving industry a more gradual transition. At the same time, the Market Stability Reserve's intake rate is reduced from 24% to 12%. The Commission's Review found that the higher rate had served its purpose, and that a lower rate better reflects the shrinking market. This reduces the risk that too many allowances are withheld from the market and keeps the Reserve aligned with the shrinking cap.
- More flexibility on free allocation. For sectors covered by CBAM, the phase-out of free allocation has also been slowed and extended to 2038. Sectors exposed to carbon leakage, but not covered by the CBAM, will continue to benefit from free allocation and carbon leakage list protection through to 2040.
- The use of international credits remains conditional. A widely debated facility would allow the purchase of up to 260 million tonnes of international credits between 2036–2040. This remains conditional on the availability of high-integrity credits. The Commission is required to report on the state of that market by 31 January 2033, and if enough credits are not available by then, the LRF automatically reverts to 2.7% from 2036 (instead of the proposed 1.7%), resulting in steeper domestic reduction.
- ETS proceeds remain a key funding source for EU decarbonisation projects: The proposal envisages the Industrial Decarbonisation Bank ("IDB") as a new EU-level support mechanism for upscaling and deploying technologies and techniques which directly reduce emissions in stationary installations. Alongside the IDB, the Innovation Fund remains in place and will be further extended.
The proposal is not yet settled as the final text and remains open to amendment between the Council and European Parliament, including the LRF trajectory, the free allocation conditionality requirements, and extensions of scope for aviation, maritime, and waste incineration. The proposal has entered the ordinary legislative process, under which the European Commission, Council, and European Parliament must agree on a final text, with political agreement targeted for Q1 2027.
Notably, there have been calls by stakeholders for the legislative negotiations on the ETS Review not to reopen the timeline for the separate emissions trading system for buildings, road transport and additional sectors (ETS2), alongside support for an early, confirmed timeline for linking the EU and UK emissions trading systems to deepen liquidity and enable mutual exemption from CBAM.3
2. EU CBAM
The CBAM's definitive regime has applied since 1 January 2026, following a transitional reporting-only period that ran from 1 October 2023. Under the CBAM, importers of covered goods (currently aluminium, cement, electricity, fertilisers, hydrogen, and iron and steel) must purchase CBAM certificates corresponding to the embedded greenhouse gas emissions in those goods. The certificate price mirrors the carbon price that would have been payable under the EU ETS had the goods been produced in the EU.4
In parallel with the downstream scope extension and anti-circumvention proposal discussed below, the Commission continues to adopt implementing and delegated acts operationalising the definitive regime,5 including rules on the calculation of embedded emissions and the CBAM certificate price.6 A further implementing regulation on the conversion of a carbon price paid in a third country into a reduction of CBAM certificates to be surrendered,7 remains in draft pending adoption.
The CBAM downstream scope extension and anti-circumvention proposal issued on 17 December 2025 is similarly still subject to the ordinary legislative process;8 most of its changes, including the extension of scope to downstream steel and aluminium goods, are intended to apply from 1 January 2028, while the revised rules for imported electricity are intended to apply (retroactively) to imports from 1 January 2026.
Both co-legislators have since taken their positions on that proposal. The European Parliament adopted its negotiating mandate on 15 September 2026.9 The Council had separately agreed on its own negotiating position on 12 June 2026.10 The institutions will now meet in trilogue to discuss the proposal.
1 Proposal for a Directive of the European Parliament and of the Council amending Directive 2003/87/EC and Decision (EU) 2015/1814 as regards driving competitiveness and cost-effective decarbonisation, COM(2026) 616 final, 17 July 2026.
2 Recent developments in this respect include the separate ETS Market Stability Reserve amendment, on which the Council and Parliament reached a provisional agreement on 20 October 2026 to retain invalidation but raise the threshold from 400 million to 700 million allowances (Council press release, 21 October 2026). Of note is also the adoption of Decision (EU) 2026/2402 of 21 October 2026 amending Decision (EU) 2015/1814 as regards the market stability reserve for buildings, road transport and additional sectors (ETS2), published in the Official Journal on 28 October 2026 and entering into force on 17 November 2026. Finally, the European Commission's fallback-benchmark proposal (COM(2026) 619 final; 2026/0211(COD)) also remains pending in the EU's legislative process.
3 The intended linkage was announced in May 2025. See White & Case alert of 21 May 2025, Upcoming revisions to EU carbon pricing and UK linkage.
4 Regulation (EU) 2023/956 of the European Parliament and of the Council of 10 May 2023 establishing a carbon border adjustment mechanism.
5 See the Commission's published CBAM initiatives, available at Published initiatives.
6 Commission Implementing Regulation (EU) 2025/2547 of 10 December 2025 on the calculation of embedded emissions; Commission Implementing Regulation (EU) 2025/2548 of 10 December 2025 on the calculation and publication of the price of CBAM certificates; as well as Regulation (EU) 2025/2083 of the European Parliament and of the Council of 8 October 2025.
7 Draft Commission Implementing Regulation laying down rules for the application of Regulation (EU) 2023/956 as regards the conversion of the carbon price paid in a third country into a corresponding reduction in the number of CBAM certificates to be surrendered, and its Annexes I to IV (as at the date of this note, not yet adopted).
8 Proposal for a Regulation amending Regulation (EU) 2023/956 as regards the extension of its scope to downstream goods and anti-circumvention measures, COM(2025) 989 final, 17 December 2025.
9 European Parliament, Press Release, "Strengthening the EU carbon border adjustment mechanism and closing loopholes", 15 September 2026, available at: https://www.europarl.europa.eu/news/en/press-room/20260911IPR47450/.
10 Council of the EU, Press Release, "Council moves to strengthen the EU's carbon border adjustment mechanism", 12 June 2026, available at: https://www.consilium.europa.eu/en/press/press-releases/2026/06/12/.
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