We also have new positions following the Commission President’s remarks at the March EUCO on ETS1: MSR invalidation mechanism, the ETS investment booster, and the Free allocation phase out for CBAM sectors.
Why do we need a strong Linear Reduction Factor (LRF) and Market Stability Reserve (MSR)?
Carbon pricing is a proven tool to reduce GHG emissions. The EU Emissions Trading System or EU ETS (hereafter referred to as ETS1) puts a price on carbon, pushing industry to internalise their environmental impact. As a cap-and-trade system, it provides a predictable long-term investment signal. By equalising the marginal abatement cost across sectors, it ensures emissions are reduced where it is cheapest to do so, promoting cost-effective decarbonisation.
The Linear Reduction Factor (LRF) and Market Stability Reserve (MSR) have been absolutely critical in ensuring such a strong and predictable price signal.
For example, the LRF increased from a mere 2.2% points to 4.3% as of 2024 and 4.4% as of 2028, meaning that industries need to progressively reduce emissions over time in line with the EU’s 2050 climate neutrality objective. This provides a long-term investment certainty that the ETS1 costs will continue to rise predictably and encouraging confident, large-scale investments in clean technologies. This stability ensures that companies can predictably plan without the risk of policy reversals, accelerating the transition to a clean economy
Furthermore, to address major surpluses of allowances in the ETS1, the Market Stability Reserve (MSR) with its 24% intake rate and invalidation mechanism entered into force in 2019. A key part of the ETS1, the MSR has removed nearly 4 billion surplus allowances and invalidated over 3 billion since 2023.
The LRF and MSR are therefore the cornerstones of ETS1 and have pushed carbon prices to levels that can finally start influencing clean industry investments. In an increasingly scarce market, it will be essential to make sure that these instruments continue to provide predictability and avoid strong price fluctuations.
Should the LRF and MSR change in the upcoming ETS1 revision?
Given the LRF’s role in ensuring a meaningful and predictable carbon price, we believe the Commission should maintain the 4.4% LRF after 2028 to guarantee investor certainty for cleantech solutions.
The MSR is another matter. The ETS1 is now moving into a new era characterised by structurally lower surpluses. It is therefore logical that the functioning of the MSR is reassessed in light of this new reality. In a structurally tighter market, the current release mechanism can have serious consequences as the market gets tighter over time and the abatement pressure on ETS1 installations grows. For example, 100 million allowances released in 2019 would have equaled 5% of that year’s cap, whereas 100 million allowances in 2035 would represent no fewer than 23% of that year’s cap.
The Business for CBAM Coalition therefore proposes to make the MSR more dynamic. It should become a counter-cyclical measure that reacts to changes in the Total Number of Allowances in Circulation (TNAC), rather than just levels. It should distinguish between expected TNAC declines and unexpected TNAC movements (i.e. shocks). By doing so, it can help preserve political predictability and avoid discretionary intervention.
Such a “TNAC-change MSR” works as follows:
- If the TNAC declines in line with the ETS total cap, do nothing.
- If the TNAC declines too fast, release allowances.
- If the TNAC increases unexpectedly, absorb allowances.
Two remaining questions related to the future of the MSR are about:
- What to do with the MSR’s invalidation mechanism. Currently, any allowances in the MSR above a 400-million threshold are permanently invalidated. We believe this mechanism should not be tampered with.
- Whether MSR allowances will again be put back into the market artificially. Market confidence was severely damaged by the Commission’s 2022 REPowerEU proposal to raise €20 billion by releasing MSR allowances early. This has risked undermining predictability and increasing price volatility. The Business for CBAM Coalition therefore strongly advises against doing this again. The MSR should no longer be a piggy bank for plugging financial gaps elsewhere.
How to maximise investor certainty?
Many companies have invested or are planning to invest in low-carbon solutions on the anticipation that the ETS1 price increases gradually. Beyond an effective LRF and MSR, investor certainty can be improved if three things happen:
Investment signal #1: Maintain the current free allocation (FA) phase out trajectory for CBAM sectors
The FA phase-out trajectory for CBAM sectors must be maintained. Claims that CBAM’s phase-in and the corresponding FA phase-out harms industry are premature. This is because CBAM will hardly impact the phase-out of ETS1 FA in the first two years – only 2.5% in 2026 and 5% in 2027. Furthermore, the ETS1 Directive under Article 10a already includes provisions for the FA phase-out to be potentially mitigated in case CBAM does not provide enough protection against carbon leakage. No further measures are needed and will only be counter-productive.
By 2030, all ETS1 sectors should ideally be covered by CBAM, as stated in the CBAM regulation (recital 67). This would ensure a uniform carbon price for all major emitters, domestic or imported. Without CBAM, EU producers will continue to face higher carbon costs than importers.
Investment signal #2: Prevent international carbon credits & temporary removals from entering the CBAM and ETS1
Some voices are calling to open the door for the use of international (Article 6 Paris Agreement) carbon credits under the CBAM and ETS1. There is a track record of social and environmental integrity issues with international credits, which is why the EU phased them out. If Article 6 international credits were to be added, the European Scientific Advisory Board on Climate Change warns they could fundamentally weaken the ETS1 as it removes the incentive to decarbonise domestically. We strongly urge the EU institutions from refraining to add any link to international carbon credits in ETS1.
In a similar manner, temporary removals such as carbon farming or forestry should be barred from ETS1. Temporary removals carry high reversal risks and are not equivalent to permanent fossil emissions. For example, trees can burn, die or be cut, and regrowth takes decades to match the original impact. In part due to their dubious nature, temporary removals are much cheaper (USD 2–30/ton) than permanent ones or the ETS1 carbon price. Including them in the ETS1 would severely weaken the carbon price signal and deter decarbonisation investments within the EU, crucial for increasing our long-term competitiveness.
If carbon removals are included, only permanent removals should be eligible. Certification methodologies remain uncertain, and according to the Öko Institut, permanent removals from DAC or BECCS should be measured at the storage stage due to CO₂ losses during capture and transport.
Investment signal #3: Make the Innovation Fund (IF) fit-for-purpose
The Innovation Fund (IF) clearly serves a purpose, given that calls are 6-7 times oversubscribed. Many of these applications are considered to be eligible for support but given the IF’s limited budget not all the eligible projects can get funding. This is another reason why it is a bad idea to postpone the phase out of FA. The FA taken from CBAM sectors would go into the IF and potentially into the to-be-created Industrial Decarbonisation Bank (IDB), so postponing the phase-out will deplete the main source of future allowances for the IF and IDB.
Unfortunately, the IF’s design is biased in a sense that it tends to favour incumbents and solutions that more easily demonstrate a green premium: For example, virtually all funding for large-scale cement decarbonisation projects went to carbon capture and storage (CCS) and virtually nothing to clinker-reduction solutions. This disadvantages cleantech scaleups with disruptive, cost-competitive technologies. Long application timelines further reduce relevance for fast-moving innovators and often fail to align with private investment decisions or project timelines. The IF should therefore be more balanced between supporting traditional players and cleantech scaleups that often do not have the balance sheets to comply with the current IF’s design.
Investment signal #4: Do not reduce the scope of ETS1
Some voices in the chemicals industry are calling to temporarily suspend the sector from the ETS1. This would be one of the most detrimental signals to investment certainty, so the Business for CBAM Coalition strongly opposes such calls. The point should rather be to increase the ETS1’ legitimacy and effectiveness by selectively expanding the scope. In particular international aviation, which represents the large majority of aviation’s CO2 emissions, as its inclusion would support the business case of emerging sustainable aviation fuel business models based on fossil-free hydrogen derivatives (e-SAFs). Another sector includes municipal waste incinerators to improve the business case for recycling.
Should ETS1 product benchmarks be changed?
The latest ETS1 revision converted several product benchmarks into technology-neutral benchmarks. An example of this is iron ore. What used to be the product-specific sintered iron ore benchmark – excluding pellet iron ore producers whose product is a lot cleaner – was changed into the agglomerated iron ore benchmark including both sintering and pelletisation plants. Similarly, a technology-neutral hydrogen benchmark was introduced.
For some products, however, product-specific benchmarks still exist. For example, in cement production separate white and grey clinker benchmarks still apply, while producers that do not produce clinker are excluded altogether. This creates a clear perverse incentive: cement producers are effectively encouraged to keep producing and using clinker, while clinker is responsible for more than 90% of cement-related emissions. A technology-neutral cement benchmark would establish a level playing field and provide a stronger incentive for producers to decarbonise by reducing clinker use or adopting alternative production pathways. Another example of such a product-specific benchmark is lime, where the product benchmark states lime can only be produced in a kiln. Technology-neutral ETS1 benchmarks are urgently needed for these products as of 2030, and the ETS1 Directive’s Annex I should be adjusted accordingly.
About the Business for CBAM Coalition
The Business for CBAM Coalition brings together businesses and business associations committed to upholding the ambitions of the Carbon Border Adjustment Mechanism (CBAM) and consequently of the EU Emissions Trading System (ETS). These policies are essential – not only for the EU’s path to cost-effective decarbonisation, but also for securing the long-term competitiveness of European industry in a rapidly evolving global economy. Contact the secretariat via info@businessforcbam.eu