EU ETS Reform, CBAM and Industrial Emissions: What Industry Faces

Why the EU ETS reform matters for industry

The EU Emissions Trading System (EU ETS) covers power plants, energy-intensive industry, aviation and maritime transport. Installations must surrender one allowance for each tonne of CO2 emitted. For decades, industrial installations received a large part of their allowances free of charge to protect them from carbon leakage – the relocation of production to countries without carbon pricing. The EU ETS reform adopted in 2023 by Directive (EU) 2023/959 changed this by tightening the cap and linking the phase-out of free allocation to the new carbon border adjustment mechanism (CBAM), which puts a carbon price on imports.

For German industry, the consequences are significant. As free allocation decreases, carbon costs rise for steel, cement, aluminium, fertilisers, hydrogen and other CBAM goods. At the same time, the Commission's review published on 17 July 2026 proposes to slow the phase-out and attach conditions to free allocation, and the revised Industrial Emissions Directive tightens permit requirements. Companies must plan investments against a moving legal target.

This article explains the current cap and free allocation rules, CBAM, the July 2026 proposal, the revised Industrial Emissions Directive and practical implications.

Cap and free allocation under current law

The EU ETS cap decreases each year by the linear reduction factor. Under Article 9 of the Emissions Trading Directive 2003/87/EC, as amended, the linear factor is 4.3% from 2024 to 2027 and 4.4% from 2028, with additional one-off reductions of the cap in 2024 and 2026. The result is a steep decline in the number of allowances available.

Free allocation is calculated on the basis of product benchmarks, historical activity levels and carbon leakage exposure. For goods covered by CBAM, Article 10a(1a) of the directive reduces free allocation by a CBAM factor. The CBAM factor is 97.5% in 2026, 95% in 2027, 90% in 2028, 77.5% in 2029, 51.5% in 2030, 39% in 2031, 26.5% in 2032 and 14% in 2033. From 2034, no CBAM factor applies – meaning that, under current law, free allocation for these goods ends. Allowances freed up by this reduction go to the Innovation Fund.

Conditions on free allocation

Already under the 2023 reform, free allocation is partly conditional. Installations subject to energy audits must implement recommendations or face a reduction, and installations with high emission intensity must prepare climate neutrality plans. These conditions will be strengthened under the Commission's proposal.

The carbon border adjustment mechanism

CBAM, established by Regulation (EU) 2023/956, applies to imports of iron and steel, aluminium, cement, fertilisers, hydrogen and electricity. After a transitional reporting phase, the definitive period began on 1 January 2026. Importers must be authorised CBAM declarants and will have to surrender CBAM certificates corresponding to the embedded emissions of their imports, reduced by any carbon price paid in the country of origin and by the free allocation still granted to EU producers.

The simplification regulation (EU) 2025/2083 introduced a single mass-based threshold of 50 tonnes per importer and year: importers below this threshold are exempt. It also postponed the sale of CBAM certificates on the common central platform to 1 February 2027. For German importers and producers in CBAM sectors, CBAM and the phase-out of free allocation are two sides of the same coin: as EU producers lose free allowances, importers pay a growing CBAM charge.

Downstream products and exports

CBAM currently covers basic materials and some simple products, not most downstream goods. This creates a risk that production of downstream products moves outside the EU. Exporters of CBAM goods also face higher costs without a border adjustment for exports. Both issues are part of the political debate and of the Commission's review.

The Commission's EU ETS reform proposal of July 2026

On 17 July 2026, the Commission published its proposal for a review of the EU ETS, aligned with the EU's 2040 climate target. According to the Commission's questions and answers, the key elements include:

• a lower linear reduction factor of 3.7% for 2031 to 2035 and 1.7% for 2036 to 2040;
• from 2031, full free allocation only for installations that prepare independently verified decarbonisation plans and invest an amount equal to the value of their free allocation in decarbonisation in the EU;
• a slower phase-out of free allocation for CBAM sectors, extended to 2038;
• integration of up to 250 million tonnes of permanent domestic carbon removals certified under the EU certification framework;
• a halving of the intake rate of the market stability reserve from 24% to 12%; and
• an Industrial Decarbonisation Bank with a target of EUR 100 billion, with a first phase financed by 400 million allowances.

The proposal now goes through the ordinary legislative procedure in the European Parliament and the Council. Its content may change considerably. Companies should treat the current rules as binding and the proposal as a scenario, not as settled law.

Implications of the proposal

If adopted, the proposal would give CBAM sectors more time and more free allowances, but it would also make free allocation dependent on investment commitments. Companies that receive free allocation would need credible decarbonisation plans and documented investments. This shifts the question from "how many allowances will we receive?" to "what must we invest to keep them?".

The revised Industrial Emissions Directive

Alongside emissions trading, the Industrial Emissions Directive (IED) governs permits for large industrial installations, with requirements based on best available techniques (BAT). The revised directive, Directive (EU) 2024/1785, had to be transposed by Member States by 1 July 2026 (Article 4). It introduces stricter emission limit values within BAT ranges, environmental management systems, new rules on penalties and compensation for damage to health, and the possibility of transformation plans that give operators time to implement deep industrial transformation. It also extends the scope to further activities.

In Germany, the IED is implemented mainly through the Federal Immission Control Act and its ordinances. Operators should check how the transposition affects their permits, particularly at the next permit review. Our article on immission control permits explains the permit system.

EU ETS reform timeline and legislative process

The current framework results from the 2023 EU ETS reform, which was part of the "Fit for 55" package aimed at reducing net greenhouse gas emissions by at least 55% by 2030 compared with 1990. That package also created CBAM, the separate emissions trading system for buildings and road transport, and the Social Climate Fund. The 2040 target, now set in the European Climate Law by Regulation (EU) 2026/667, requires a further revision of the ETS rules for the period after 2030, which is what the July 2026 proposal addresses.

The next EU ETS reform will be negotiated between the European Parliament and the Council during 2026 and 2027. Industry associations, Member States and environmental organisations have taken very different positions: some argue that the phase-out of free allocation threatens industrial competitiveness, while others argue that the proposal weakens the carbon price signal. The final compromise may differ substantially from the proposal, particularly on the phase-out timeline for CBAM sectors and on the conditionality of free allocation.

What stays the same

Whatever the outcome, the core mechanics remain: a declining cap, auctioning as the default, benchmark-based free allocation for sectors at risk of carbon leakage and annual surrender of allowances. Companies can therefore build their compliance processes on the current system and adapt parameters as the law changes.

Market stability and prices

The market stability reserve absorbs surplus allowances and releases them when supply is short. Changes to the reserve affect prices: a lower intake rate keeps more allowances in circulation, which tends to dampen prices. Because the EU ETS reform proposal combines a slower cap decline after 2030 with changes to the reserve, analysts expect a different price path than under current law. Companies hedging carbon costs should review their strategies once the legislative outcome becomes clearer.

Practical implications for companies

After the EU ETS reform, carbon costs are a central factor in industrial investment. Companies should model their allowance position under current law and under the Commission's proposal, including the CBAM factor, benchmark updates and conditionality. Long-term supply contracts for CBAM goods should allocate carbon costs and CBAM charges clearly, and procurement teams should verify embedded emissions data from non-EU suppliers.

Funding instruments can close the gap. Germany's climate protection contracts compensate the additional costs of low-carbon production, taking free allocation into account, and the EU Innovation Fund supports breakthrough technologies. For process emissions that cannot be avoided, carbon capture and storage may become a viable option as carbon prices rise.

Mergers and acquisitions

In transactions involving energy-intensive companies, buyers should analyse the target's allowance position, free allocation applications, compliance history, CBAM exposure and IED permit status. Changes in installations can affect free allocation, and the transfer of installations must be notified to the authorities.

Contracts with customers

Producers of CBAM goods should also review their sales contracts. As free allocation declines, carbon costs per tonne of product rise, and customers may resist price increases. Price adjustment clauses linked to carbon costs, clear definitions of "carbon cost" and rules for changes in law help to pass costs on in a transparent and enforceable way. For low-carbon products, contracts may include green premiums and certification requirements.

German administration

In Germany, the German Emissions Trading Authority (DEHSt) at the Federal Environment Agency administers free allocation, CBAM and compliance. Applications for free allocation for the next allocation period must be made on time and with verified data; mistakes can lead to lower allocation that is difficult to correct later. Objections against allocation decisions are subject to short deadlines, and court proceedings before the administrative courts can take years, so careful preparation of the application is the best protection.

How TRW & Co helps with the EU ETS reform

We advise energy-intensive companies, importers and investors on the EU ETS reform, CBAM and the revised Industrial Emissions Directive. We analyse allowance positions and free allocation, support CBAM authorisation and compliance, review supply contracts for carbon cost allocation, advise on permits and transformation plans, and represent clients before the DEHSt and the courts. Our work connects with our chemicals, manufacturing and compliance and ESG teams. Please contact us. This article is general information and not legal advice.