- The EU Emissions Trading System (ETS) is at a political and structural inflection point, with allowance prices falling sharply by around -24% in the first two months of 2026. The conflict in Iran and associated energy price and inflation expectations have additionally spurred proposals to use the ETS as a lever for short-term price relief. Unlike earlier episodes of price volatility rooted in energy-market fundamentals, the current turbulence reflects growing political questioning of the ETS's long-term design, compounded by concerns over industrial competitiveness as free-allowance phase-outs begin. Geopolitical pressure around Iran adds to this risk. The use of ETS revenues for price support or direct market intervention risk defeating the steering purpose of the system or creating dangerous lock-in effects.
- Three ETS fault lines: free allocation has shielded more than 90% of industrial emissions from direct carbon costs but this is set to change; the ETS has driven substantial emission reductions in the power sector but not in industry and revenue recycling is falling short of its potential. At current prices, full exposure would cost 0.9% of gross value added in the industry sector, a real burden for energy-intensive firms that cannot pass carbon costs through to customers given high energy costs, strong international competition and the limited offsetting potential of the Carbon Border Adjustment Mechanism (CBAM). Since 2005, power sector emissions have fallen by -54%, while industrial combustion emissions declined by a more moderate -33%. Renewables have made decarbonization viable at prices below EUR50/tCO2, while industrial options such as green hydrogen and low-carbon steel carry abatement costs well in excess of EUR100/tCO2. Persistent price uncertainty, with allowances oscillating in a EUR50–98/tCO2 corridor since 2022, has further weakened the investment case for capital-intensive industrial transformation. Last, only 16% of recycled revenues flow back into energy and industry, the sectors directly covered by the ETS, while 51% is directed toward non-covered sectors. A cumulative EUR41bn went undeployed for climate action between 2013 and 2024, risking a financing trap where industry bears rising carbon costs without the capital needed to decarbonize.
- ETS2 is better positioned than ETS1 but that advantage is eroding. Unlike ETS1, where abatement economics were the binding constraint, low-carbon alternatives in transport and buildings are already cost-competitive. The remaining barriers are political and financial: EUR113bn in annual fossil-fuel subsidies undermining the price signal, policy reversals on fossil boiler phase-outs, unaffordable EVs and financing frameworks still unequipped to meet household-level transition costs at scale. With household exposure potentially reaching EUR420 per year by 2030, these are policy choices that should be addressed before the carbon price arrives in 2028.
- The ETS does not need a redesign but rather targeted reforms to restore price credibility and close the investment gap. Seven priorities stand out: establishing a credible long-run EUA price corridor; scaling up Carbon Contracts for Difference to bridge the abatement cost gap in hard-to-abate sectors; introducing binding revenue recycling standards linked to the new decarbonization bank; prioritizing shared infrastructure for CO2 transport, hydrogen and industrial clusters; conditioning the free allowance phase-out on the availability of abatement technologies and transition funding; expanding CBAM to cover downstream sectors currently left exposed and ensuring ETS2 revenues are transparently earmarked for households most exposed to its regressive cost distribution.