On 18 December 2022, the European Commission, the European Parliament, and the Council of the EU finalized a provisional agreement on a broad set of policy proposals of the "Fit for 55" package, including a landmark reform of the EU ETS. This agreement marks the successful end of the “trilogue negotiations” between the three European institutions, as agreement on other parts of the package, including the Carbon Border Adjustment Mechanism, has already been reached. Originally presented by the European Commission in July 2021, the "Fit for 55" reforms are needed for the European Union to meet its emissions reduction target of 55% by 2030 and to achieve climate neutrality by 2050. The agreement is provisional awaiting formal adoption by the Parliament and the Council, and the final text of the agreement is therefore not yet published.

The agreements represent a defining milestone for the EU ETS, and for carbon pricing more broadly, effectively placing emissions trading at the heart of the EU’s decarbonization agenda. Building upon the 2030 Climate Target Plan, the deal includes a more ambitious reduction target for the EU ETS sectors of 62% by 2030; the phase out of free allocation in some sectors accompanied by the phase-in of the carbon border adjustment mechanism (CBAM); revised parameters for the Market Stability Reserve (MSR); the expansion of the EU ETS to cover maritime shipping; a new and separate ETS for buildings, road transport, and other fuel sectors (ETS 2); and a strengthened commitment to use ETS revenues to address distributional effects and spur innovation. The key elements on the provisional agreement are outlined below.

EU ETS cap, trajectory, and rebasing

To achieve the target of at least 55% net reduction in greenhouse gas emissions below 1990 levels by 2030, as outlined in the European Climate Law, co-legislators committed to greater emissions reductions under the EU ETS, setting a target of 62% below 2005 levels by 2030. This is an increase compared to the 61% target originally proposed by the European Commission in the Fit for 55 proposal, and a significant increase from the previous 43% target. To accomplish this, the agreement raises the linear reduction factor (LRF) from 2.2% to 4.3% from 2024-2027 and to 4.4% from 2028-2030. Furthermore, the agreement includes two one-off ‘rebasings’ of the cap, reducing it by 90 million allowances in 2024 and an additional 27 million in 2026.

Carbon border adjustment mechanism

To address higher risks of carbon leakage in light of increased climate ambition within the EU, the Council and Parliament agreed on a phase-in plan for CBAM to price imported goods based on their embedded emissions. Starting in 2026, importers in sectors covered by CBAM (cement, aluminum, fertilizers, electricity, hydrogen, iron and steel, along with some precursors and downstream products) will be required to surrender newly created CBAM certificates equivalent to the embedded emissions of their products. In contrast to the original Commission proposal, indirect emissions will also be covered.

The CBAM phase-in plan gradually ceases the free allocation of EU ETS allowances over a nine-year period (from 2026 to 2034) for sectors covered by CBAM. The phase-out of free allocation will begin at a slow rate before accelerating towards the end of the period. The phase-in will be complementary, so that during the transition period CBAM will only apply to the proportion of emissions that are not subject to free allocation under the EU ETS.

Market stability reserve

The market stability reserve (MSR) is the main instrument for addressing supply and demand imbalances in the EU ETS and bolstering its resilience to external shocks. It is set to be strengthened by prolonging the annual intake rate of allowances of 24% (initially scheduled to be reduced to 12% from 2023 onwards) until 2030.  Furthermore, the agreement will restrict the number of allowances that can be held in the reserve to 400 million, with any surplus being permanently cancelled.

EU ETS scope expansion

The agreement foresees the gradual inclusion of maritime sector emissions into the EU ETS, with the obligation to surrender allowances rising from 40% of verified emissions in 2024 to 100% in 2026. By the end of 2026, the Commission will also assess whether to introduce emissions from municipal waste incineration into the EU ETS from 2028.

New ETS for buildings, road transport, and other fuels

In parallel, the agreement establishes a separate emissions trading system for direct emissions from the buildings, road transport, and other fuel-consuming sectors. The new ETS 2 will complement the EU ETS sectoral coverage, broadening EU-level carbon pricing to cover all major sectors of the economy except agriculture and land-use. In light of the impact of the energy crisis, the new system is set to come into force in 2027, one year later than the European Commission originally proposed. However, as a means of safeguarding vulnerable households, the ETS 2 will be delayed to 2028 if energy prices are deemed exceptionally high (more than 106€/MWh for gas and oil).

To give the new system a smooth start, it was agreed to frontload the supply of allowances by auctioning an additional 30% in the first year of operation. A new price stability mechanism has also been agreed, so that if the allowance price exceeds EUR 45 per tonne over a specified period, market supply shall be increased by releasing an additional 20 million allowances.

ETS revenue use

Revenues from the ETS 2 will flow into a newly established Social Climate Fund. This fund is designated to address the financial burden of citizens and micro-enterprises most impacted by energy price rises, particularly for heating and transport, resulting from the new carbon price. The EU ETS’s existing Innovation Fund is also set for a significant boost, with funding (coming from the auctioning of dedicated allowances) rising from 450 million to 575 million allowances in the period 2020-2030.

Next steps

At this stage, the EU has only issued a detailed press release on the agreement. The official text of the agreement is expected to be published in mid-January, after the Commission, the Council and the European Parliament agree on final technical details. The provisional agreement will then require formal approval from the Parliament and the Council before the law can come into force. Full adoption of the agreement is expected by April 2023.

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