EU ETS2 – Testing the Boundaries of Cap and Trade Systems

At a glance

EU ETS2, the new EU cap and trade regime, with monitoring obligations that kicked off in 2024, will soon give rise to surrender obligations for a new category of allowances from 2027. This mechanism deviates from the current emissions trading system by not following the ‘polluter pays’ principle and therefore, operates differently from the current system.

Futures contracts in support of EU ETS2 allowances are being launched in 2025 in anticipation of the first full compliance year in 2027, even though over-the-counter trading documentation has not yet been developed. With no free allocation and all purchases being made by auction only, the supply of EU ETS2 allowances will not be seen before 2027. However, analysts are expecting supply scarcity to impact this new market significantly, leading to an anticipation that market participants may wish to trade ahead.

What is EU ETS2?

This is a new cap and trade emissions trading system (“EU ETS2“), distinct from the existing EU emissions trading system established in 2004 (“EU ETS1“), introducing new regulated sectors comprising of road transport, buildings and small energy and industry installations (“Covered Sectors“). EU ETS2 arose as part of the EU’s ‘Fit for 55’ package of legislative amendments, aimed at reducing net greenhouse gas emissions by at least 55% by 2030 compared to 1990 levels.

Despite being a distinct cap and trade regime from EU ETS1, EU ETS2 uses much of the infrastructure of EU ETS1 and therefore, the legislation to implement it was essentially a law that amends the EU ETS Directive¹. EU Directive 2023/959, amending the EU ETS Directive, came into force on 5 June 2023.

Context and background to EU ETS2

Although EU ETS1 is often cited as the primary tool used to achieve decarbonisation in the EU, it has never been the case that sectors outside EU ETS1 were unregulated. Many sectors, for which distinct EU-level legislative policies have not been introduced, fell within the scope of Effort Sharing Regulation (“ESR“).² The ESR aims collectively to reduce Member States’ emissions from these sectors by 40% by 2030 against 2005 levels and allocated targets for achieving this to the Member States who, in turn, determine their own national polices and approaches (e.g. local taxes) to deliver the outcomes.

However, the ESR was not seen to be delivering results consistent with the revised Fit for 55 targets. Until 2021 under the ESR, the sectors that are now Covered Sectors under EU ETS2, had only achieved an 11% emission reduction against a 2005 baseline. Bringing the sectors within a cap and trade framework was considered a more effective way to achieve the revised decarbonisation targets. Under EU ETS2, emissions in the buildings and road transport sectors should be reduced by 43% by 2030 compared to 2005, and emissions in the other covered sectors should be reduced by 42% by 2030 compared to 2005. To put it simply, to meet the EU ETS2 targets, the Covered Sectors will effectively have to reduce emissions five times faster than they were doing up to now under the ESR.

Activities covered by EU ETS2

With the inclusion of the Covered Sectors into EU ETS2, the European Commission estimated that approximately 11,400 entities across the EU would become regulated entities, including 7,000 oil tax warehouses, 1,400 regional and local gas suppliers and 3,000 coal suppliers (“EU ETS2 Regulated Entities“).

A key feature that distinguishes EU ETS2 from EU ETS1, is that the cap and trade approach does not follow the ‘polluter pays’ principle and instead targets actors (i.e. EU ETS2 Regulated Entities) which ‘release for consumption of fuels used for combustion‘ in the Covered Sectors (the “Regulated Activity“). In doing so, EU ETS2 moves the point of regulation further upstream. The reasons for this are discussed further below.

The list of Regulated Activities is now set out in Annex III of the EU ETS Directive. Recognising the risk of overlap with other existing EU climate policies, including EU ETS1, the EU ETS2 Regulated Entities are not caught by the scope of EU ETS2 where the Regulated Activity relates to:

1. the release for consumption of fuels used in the activities covered by EU ETS1;
2. the release for consumption of fuels for which the emission factor is zero; or
3. the release for consumption of hazardous or municipal waste used as fuel.

We do not propose to provide a list of Covered Sectors because this would involve a lot of technical detail. The attempt to address overlaps with other EU regulations has led to the Regulated Activities being listed with plenty of nuance. For example, Combined Heat and Power Generation (CHP) and Heat Plants, which are covered by the scope of EU ETS1, are now caught by EU ETS2, insofar as they produce heat for commercial / institutional and residential, either directly or through district heating networks. Previously, the majority of the heat market, was excluded from EU ETS1 because it fell below the thermal input of 20MW threshold. Road transport is included but not rail transport, agricultural vehicles on paved roads or when used off-road, emissions from other modes of transportation such as commercial aviation, private aviation, commercial water-borne and maritime navigation, private water-borne and maritime navigation, military operations, etc.

Types of fuel covered by the EU ETS2 include leaded and unleaded petrol, gas oil, kerosene, LPG, natural gas, heavy fuel oil, coal and coke, fuel of biological origin such as biodiesel and biokerosene and any other product intended for use, offered for sale or used as motor fuel or heating fuel as specified in Article 2(3) of the Energy Taxation Directive. This includes any fuel additives used as motor fuel, certain bio-based fuels, and any other hydrocarbons for heating purposes. However, peat, wastes used as fuels (hazardous or municipal wastes used as fuel, as explicitly excluded from the Annex III of EU ETS Directive), solid biomass (such as wood-based fuels) and charcoal from wood are excluded.

It is worth noting that Annex III of the EU ETS Directive explicitly excludes from EU ETS2 activities listed in Annex I (which identifies activities covered by EU ETS1). Therefore, any fuel released for consumption and to be combusted in an installation, an aircraft or ship covered by EU ETS1 is excluded from the Regulated Activities of an EU ETS2 Regulated Entity caught for that same activity but for a different consumer group under EU ETS1. Member States are given the option to extend the Regulated Activities to sectors beyond those in Annex III after 2027. The EU Commission is empowered to agree to such an extension and adopt corresponding delegated acts.

Some Member States, such as Germany, had introduced their own national tax to achieve their ESR objectives. To accommodate the sectors already covered by a national regulation of the Regulated Activity, until 31 December 2030, where a EU ETS2 Regulated Entity established in a given Member State is subject to a national carbon tax in force for the years 2027 to 2030, the competent authority of the Member State may exempt that EU ETS2 Regulated Entity from the obligation to surrender allowances for a given year provided certain requirements are satisfied, including that the national carbon tax rate is, on average, higher than the auction price in the EU ETS2 in the same year.

As the above highlights, EU ETS2 is highly technical and, for reasons explained below, is more complex than EU ETS1.

A timeline for EU ETS2

Key differences between EU ETS1 and EU ETS2

Beyond the sectors covered, there are a number of distinctive features of EU ETS1 that differentiate it from EU ETS2. We discuss the most relevant of these below.

Why deviate from the polluter pays principle?

The main reason for the deviation is twofold: (i) reducing regulatory burden and (ii) ease of administration.

On the first reason, if the polluter pays principle were applied, it would require everyday EU citizens who are residential tenants or vehicle users to become regulated entities under EU ETS2. This would be impractical from an administrative perspective and politically unpalatable. Therefore, the EU Commission was forced to look upstream, which is where the second reason becomes most relevant.

When doing so, the EU Commission wanted to strike a balance in respect of the following factors: technical feasibility, the ability to pass on the carbon price to consumers, proportional administrative costs relative to the reduction effect and interactions and consistency with existing measures (such as Article 7 of the Energy Efficiency Directive 2012/27/EU, as amended). It recognised that one of the easiest ways to track and monitor energy flows for road transport and buildings, as distinct from other flows (including those covered by other legislative measures), would be by identifying the end-user of the fuel. Therefore, regulating at the excise duty point was identified as convenient because it allowed for the easy utilisation of the monitoring and reporting mechanisms already in place for import and excise duty purposes.

For example, for oil imports into the EU, a harmonised excise duty system applies across all Member States, with excise duty levied on tax warehouses. The goods supplied from these warehouses are subject to a differential rate of duty based on the end-user (e.g. oil products used in road transport are taxed differently from oil used in residential heating). Therefore, the supplier currently has to track, monitor and provide evidence on their end-use which, in turn, provides a solid foundation for implementing the monitoring, reporting and verification (“MRV“) requirements specific to EU ETS2.

That said, there is no harmonised tax warehouse system for gas and coal across all Member States and therefore, MRV systems would have to be adopted for gas and coal suppliers. With respect to gas, given that the market is heavily regulated and that many suppliers act as excise duty points and the data submitted by the EU ETS2 Regulated Entities, as in the case of tax warehouses, can be expected to be reliable, the incremental cost of MRV adaptation was expected to be moderate. This cannot be said for coal, as most suppliers are small and unregulated.

In the design drivers for EU ETS2, the EU Commission recognised that the incentive for adopting lower carbon alternatives to fossil fuel (e.g. adopting the use of elective vehicles in the road transport sector) would not come from the fuel suppliers but would have to come from the consumer. Therefore, the design approach of EU ETS2 was to establish a price signal that would influence the end consumer; in this case, with a model that meant the tax warehouse and fuel suppliers would, for the most part, simply pass on the cost to the end user.

The unit of allowances and allocation method

Thanks to how “allowances” are defined in the EU ETS Directive, the fact that there are now currently four different categories of compliance units capable of being used, does provide a headache for contractual draftspersons. For example, the European Energy Exchange (“EEX“)’s contract specifications for its EU allowance (“EUA“) futures contract currently don’t carve out allowances that are issued for the purposes of EU ETS2. Perhaps this will be corrected when they launch their EU ETS2 futures contract in the middle of 2025. Similarly, the definition of ‘EU Allowance’ in the latest ISDA documentation³ does not carve out REAs⁴. The four categories of allowances in the EU ETS Directive now are: (1) EUAs⁵, (2) Aviation allowances (“AEUAs“)⁶, (3) linked system allowances that come into EU ETS1 pursuant to Article 25 of the EU ETS Directive (e.g. Swiss allowances) and (4) REAs. Only REAs are capable of being delivered for compliance purposes under EU ETS2.

Unlike EU ETS1, there is no attempt to ease EU ETS2 Regulated Entities into compliance by giving any free allocation. All REAs can only be acquired though auctioning. REAs will be auctioned from 2027, unless they are placed in the MSR, and a share of the revenues will be used to support vulnerable households and micro-enterprises through a dedicated SCF. Member States will be required to use the remaining EU ETS2 revenues for climate action and social measures, and they will report on how this money is spent. REA auctions will take place separately to EUA actions. More detail on MSR is provided below.

Compliance deadlines and registry accounts

EU ETS1 and EU ETS2 will have different compliance deadlines, as shown in the table below. It is also worth noting that current ‘Trading Account’ holders in the Union Registry will be able to hold REAs together with the other allowance types but EU ETS2 Regulated Entity compliance account holders can only hold REAs and no other allowance type in a Regulated Entity holding account.

	EU ETS1	EU ETS2
Verification deadline for compliance year (N)	31 March on N+1	30 April on N+1
Surrender deadline or compliance year (N)	30 September N+1	31 May N+1

Any EU ETS2 Regulated Entity that fails to surrender sufficient REAs each year to cover its emissions during the preceding year, shall be required to pay the same compliance penalty as under EU ETS1. This means a penalty of Euros 100 (adjusted for inflation) per tonne is applicable together with an obligation, in the next compliance year, to surrender a quantity of REAs equal to the quantity the EU ETS2 Regulated Entity failed to surrender in the previous year.⁷

Lessons applied from EU ETS1 towards EU ETS2

As most readers will know, EU ETS1 has been a learning process for the EU Commission. To say that the EU ETS1 is a success today, belies the many design and policy mistakes that have been made across the 20 plus year journey of EU ETS1. Therefore, when setting out to establish a new cap and trade system with EU ETS2, the EU Commission has drawn on those experiences. This can be illustrated through a number of features such as the setting of a provisional (as opposed to final) cap on the number of REAs to be available within EU ETS2 and how the MSR will be applied to deal with supply and price constraints within the first phase of the EU ETS2.

Calculation of the Emissions Cap

The EU ETS2 cap for 2027 includes countries of the European Economic Area and the European Free Trade Association. This cap will amount to 1.036 billion REAs for 2027 and contributes to the EU achieving its 2030 climate targets. It will be subject to a linear reduction factor (“LRF“) of 5.10% from 2027 onwards and 5.38% from 2028 onwards.

The calculation of the cap for 2027 is based on the average CO2 emissions from fuel combustion in the Covered Sectors from 2016 to 2018. In short, this is not based on data that come through from a MRV process. The EUAs allocated for the first phase of EU ETS1 (2005-2007) was too high because of the absence of actual emissions data and therefore, in setting the EU ETS2 cap, the EU Commission was keen to avoid repeating that mistake.

From 2028 onwards, the baseline changes to the average emissions that have been reported within EU ETS2 for 2024-2026 and the quantity of REAs allocated, will enable the LRF to be recalculated, thereby adjusting the emissions cap. If the average emissions reported for 2024-2026 are more than 2% higher than the cap set for 2027, then the LRF is recalculated according to a specific formula. If emissions decrease faster than anticipated, the LRF of 5.38% remains unchanged. So, principally, the recalculation deals with concerns around overallocation rather than anything else.

With no free allocation of REAs, to prevent excessive price volatility, a frontloading mechanism will increase the initial supply of auctioned REAs by 30%, bringing the total auctioned allowances for 2027 to 1.347 billion. The benefit of the early auctions is that the proceeds can then fund the SCF.

Market Stability Reserve/MSR

EU ETS1 was not originally designed with a safety valve to deal with overheating of prices or oversupply of EUAs. This was bolted on to EU ETS1 in 2015 and only took effect from 2019. In the context of EU ETS2, since there is a significant correlation between the price of REAs and the effectiveness of additional climate protection measures under the Fit for 55 package, the risk of an overheated market or one where there have been too few REAs allocated in the cap is foreseeable. Put simply, the more effective the additional policy measures extraneous to the EU ETS2 are, the lower the REA price should be. For example, the more take up there is of Electric Vehicles (“EVs“) the lower the use of fuel oils is likely to be in the road transportation sector. However, any delays by Member States in banning the sale of new petrol and diesel cars from 2035 will directly impact the assumptions on which the EU ETS2 cap was based.⁸

EU ETS2 includes an MSR operated separately from the EU ETS1 MSR. The MSR will be created in 2027 with a quantity of 600 million REAs which are not part of the regular cap. On 1 January 2031, any remaining share of REAs not released into EU ETS2 will be invalidated.

The MSR has a number of pre-agreed triggers that will determine how REAs are released or deducted, as summarised in the table below:

Total Number of REAs in Circulation	Measures to be taken
> 440 million in a given year	100 million REAs will be: deducted from the number of REAs to be auctioned; and placed in the reserve over a period of 12 months starting from 1 September of the following year.
< 210 million in a given year	100 million REAs will be: released from the MSR; and added to the volume of REAs to be auctioned over a period of 12 months starting from 1 September of the following year.
< 100 million in a given year	All remaining will be released from MSR

In addition, Article 30h of the EU ETS Directive includes several measures to be taken in case of the overheating of REA prices, as summarised in the table below:

Average price of REAs	Measures to be taken
100% above the average price of the preceding 6 months	50 million REAs will be released from the MSR
50% above the average price of the preceding 6 months in 2027 and 2028	50 million REAs will be released from the MSR
200% above the average price of the preceding 6 months	150 million REAs will be released from the MSR
> EUR45 for more than 2 consecutive months (indexed on a 2020 basis)	20 million REAs will be released from the MSR (until 31 December 2029)

Progress of implementation

Progress in transposing the EU ETS Directive amendments to bring EU ETS2 into national law has been so slow that, the EU Commission launched infringement proceedings against 26 EU countries (except Austria) in July 2024. Some of these cases, such as those against Greece and Ireland, have since been closed. A number of other countries have been cleared but their proceedings have not yet been closed. Denmark was one of the first countries to transpose EU ETS2 into national law. Ireland did so in September 2024. Finland’s national law on EU ETS2 entered into force on 1 January 2025. The elections in late 2024 and early 2025 in France and Germany have had a significant bearing on the progress of implementation. This is because of the anticipated backlash that is likely to arise when the cost of EU ETS2 is inevitably passed on to the citizens of the Member States in the middle of a ‘cost of living’ crisis triggered by Russia’s invasion of Ukraine. There are various estimates in the market but according to one study, fuel prices for motorists could increase by about Euro 0.50 per litre.⁹

As mentioned above, the success of other climate policies in the EU are likely to influence the price of REAs heavily. Besides the ban on combustion fuels cars (discussed above), other measures such as subsidy cuts, biofuel competition in which the EU renewable energy targets prioritise aviation and maritime biofuels, limiting road transport availability and trade barriers, such as EU imposed tariffs on cheaper EV imports, are likely to effect the progress of decarbonisation for road transport and therefore, the price of REAs.

Replacing traditional gas boilers with heat pumps is central to the EU’s decarbonisation strategy in the building sector. The challenge is in funding the switch. Some of the subsidies to encourage the take up of heat pumps in Germany that were set aside in the German budget by the previous three-party German coalition government in its Climate and Transformation Fund, were ruled illegal by the German Constitutional Court.¹⁰ This funding gap was a factor in the eventual collapse of that coalition government. Heat pump sales across Europe fell by 47 per cent in the first half of 2024 due to fewer subsidies and lower gas prices weakening consumer incentives to switch away from gas boilers.¹¹ Pushback against the EU’s costs of decarbonisation and pressures by governments to incentivise take up will affect the progress of decarbonisation for buildings.

Although EU ETS2 anticipates the possibility of postponement, the grounds for such postponement are limited to one or both of the following conditions being met:

1. The average price for natural gas in the six months ending 30 June 2026 is higher than the average price in February and March 2022.
2. The average Brent Crude Oil price in the first six months of 2026 is more than double the average during the five preceding years.

If one or both of these conditions were met, the EU Commission would publish this in the Official Journal by 15 July 2026. The effect, for the most part, would be that the EU ETS2 would be pushed back by a year and there would be a commensurate reduction in the funding available in the SCF, which would be reduced from EUR 65 billion to EUR 54.6 billion until 2032 because of the delay to the auction process.

To allow any other grounds for postponement, there would have to be an amendment to the EU ETS2, which looks unlikely at present. If EU ETS2 becomes operational as planned, then the role of the SCF to smooth the impact of the EU ETS2 prices on consumers will become critical. The impact of increased costs borne by consumers will be more visible in low-income households due to their greater dependency on fossil fuels. A 2022 study by the WWF indicates¹² that without social welfare redistribution mechanisms, heating and energy expenditures could rise significantly (in Hungary and Latvia, the price of fossil gas heating could increase by 37%, fuel costs could increase by 32% in Belgium and in Poland, the price of coal would increase by 91%). These changes can result in an average consumption expenditure increase of 0.4-0.8% in most high-income Member States, rising to almost 2% in the low- to middle-income Member States (1.9% in Poland, 1.6% in Hungary and the Czech Republic and 1.3% in Romania).

Looking beyond 2030 and conclusion

Looking ahead, the EU ETS Directive contemplates the prospect of the extension of the Covered Sectors, for example to cover the remaining energy related carbon emissions, currently outside EU ETS1 or EU ETS2. There is also the possibility of EU ETS1 and EU ETS2 being merged at some point. However, that is unlikely to happen anytime soon as, according to Article 30i of the EU ETS Directive, this will only be considered once the EU Commission has assessed the feasibility of integrating the two and published its recommendation by 31 October 2031.

EU ETS2 faces a number of challenges in getting off the ground. The EU Commission’s original design assumptions had pegged REA prices at around Euro 40 per tonne, whereas analysts have anticipated prices in excess of EUA prices and by some margin. This has caused national legislators concern around the potential backlash from implementation of EU ETS2. However, a number of things are clear. Whilst having a number of similarities with EU ETS1, EU ETS2 is not the same and the cross-over with other EU climate policy tools will create dynamics within this mechanism that will be unique to it.

Footnotes

1. Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003 establishing a system for greenhouse gas emission allowance trading within the Union and amending Council Directive 96/61/EC https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A02003L0087-20240301.
2. Regulation (EU) 2018/842 of the European Parliament and of the Council of 30 May 2018 on binding annual greenhouse gas emission reductions by Member States from 2021 to 2030 contributing to climate action to meet commitments under the Paris Agreement and amending Regulation (EU) No 525/2013 https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A02018R0842-20230516.
3. See: Form of Part [7] to the Schedule to an ISDA Master Agreement for EU Emissions Allowance Transactions (incorporating options) (Version 8: March 8, 2024) (Phase 4 delivery).
4. Issued under Chapter IVa of the EU ETS Directive.
5. Issued under Chapter III of the EU ETS Directive.
6. Issued under Chapter II of the EU ETS Directive.
7. See Article 16(3) of the EU ETS Directive.
8. The FT, ‘Europe’s centre-right calls for softening of 2035 green car target’; 17 April 2025 Europe’s centre-right calls for softening of 2035 green car target.
9. The FT, ‘EU carbon market expansion to raise diesel prices’; 1 July 2024 EU carbon market expansion to raise diesel prices.
10. The FT, ‘German top court strikes down €60bn off-budget climate fund’; 15 November 2023 German top court strikes down €60bn off-budget climate fund.
11. The FT, ‘European heat pump sales tumble as subsidies shrink’; 27 September 2024 European heat pump sales tumble as subsidies shrink.
12. The WWF, SCF and ETS 2 impact studies, evidence review, November 2022 https://wwfeu.awsassets.panda.org/downloads/ets2_and_scf_studies_review_final__1_.pdf.

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