The European Commission has officially published its highly anticipated regulatory review proposal for the European Union Emissions Trading System (EU ETS), establishing the foundational legal architecture for Phase 5 spanning 2031 through 2040. This extensive policy overhaul serves as the regulatory cornerstone to align Europe’s primary carbon market with the legally binding European Climate Law target of an absolute 90% net reduction in greenhouse gas emissions by 2040 compared to 1990 levels. In a shifting macroeconomic landscape defined by elevated industrial energy costs and intensifying international competition, this legislative text introduces structural revisions across cap trajectories, market reserves, sectoral boundaries, and cross-border accounting rules.

Prior to this legislative proposal, the structural design of the EU ETS faced long-term supply and stability challenges that risked market volatility and premature liquidity depletion. Under the previous regulatory guidelines, a rigid extension of the existing Linear Reduction Factor (LRF) would have driven the issuance of new carbon allowances to absolute zero by roughly 2039, an abrupt timeline that could choke industrial compliance liquidity before deep decarbonization technologies matured. Furthermore, the existing Market Stability Reserve (MSR) lacked the dynamic parameters needed to prevent severe allowance shortages or sudden price spikes within a rapidly shrinking cap, while the lack of structured rules for integrating international credits and domestic technical removals threatened long-term compliance continuity.

To systematically address these structural constraints, the European Commission implemented a recalibrated supply trajectory alongside a dynamic market buffering framework. The proposal establishes a dual-rate LRF, setting an annual cap reduction of 3.7% for the 2031–2035 period before tapering to a shallower 1.7% from 2036 onward, which ensures a predictable transition that extends allowance issuance well into the 2040s. Concurrently, the MSR framework will undergo significant adjustments starting in 2028: the allowance intake rate will be halved from 24% to 12% to sustain market liquidity, while the upper and lower thresholds will contract dynamically by 4% annually to naturally mirror the contracting cap. Additionally, a new variable “lower buffer” mechanism replaces the rigid 100-million allowance release rule with a flexible, data-driven injection model.

The regulatory restructuring yields major institutional, sector-specific, and financial outcomes across the European compliance landscape. The proposal formalizes the integration of domestic technical removals by expanding the overall cap by 250 million allowances between 2031 and 2040, utilizing the auction proceeds exclusively to fund the public procurement of certified Direct Air Capture (DACCS) and Bioenergy with Carbon Capture (BioCCS) units. Structurally, the proposal incorporates international carbon credits from 2036 onward by ring-fencing 260 million allowances to finance high-integrity Article 6 credits, up to a strict 2% ceiling. Finally, the draft expands the sectoral boundaries of the market by phasing in full compliance obligations for municipal non-hazardous waste incineration between 2031 and 2034, while launching a dedicated Industrial Decarbonisation Bank to deploy performance guarantees and Carbon Contracts for Difference (CCfDs) starting in 2028.