The EU Emissions Trading System is the world’s largest carbon market and the centrepiece of European climate policy. Since its launch in 2005, it has grown from a contested experiment into the primary mechanism driving decarbonisation across European industry. For around 10,000 installations and airlines operating in Europe, it is a direct operating cost that now sits alongside energy and raw materials as a core input expense.
With EU allowance prices at €79 per tonne in May 2026, a trajectory pointing toward €100/t in 2027, and formal negotiations underway to merge the EU and UK carbon markets ahead of the July 13 summit, there has never been a more commercially consequential moment to understand how the ETS works, what it demands from companies, and how to manage exposure strategically.
What the EU ETS is and how the cap-and-trade mechanism works
The fundamental logic: making emissions financially visible
The EU ETS operates on a cap-and-trade model. The EU sets a hard ceiling (the “cap”) on the total volume of greenhouse gases that all covered installations combined can emit. Each year, that cap declines according to a predefined reduction path, making the total volume of permitted emissions smaller and smaller.
Within that cap, companies hold and trade allowances. One EU Allowance (EUA) represents the right to emit one tonne of CO₂ equivalent. Companies that reduce their emissions below their allowance balance can sell the surplus. Companies that emit more than they hold must buy additional allowances on the open market or at auction. Every tonne of CO₂ thus carries a price — and that price rises as the cap tightens.
The system does not tell any individual company how much to emit or what technology to use. It sets the overall budget for European industry and lets market prices signal where the cheapest abatement opportunities lie. The result is, in theory, that emissions reductions happen where they are most cost-effective across the economy, rather than being mandated installation-by-installation by regulators.
The annual compliance cycle
Every covered company follows the same calendar each year:
- Throughout the year: monitor emissions according to an approved monitoring plan; buy or sell allowances to manage position
- By 31 March: submit a verified emissions report to the national competent authority
- By 30 April: surrender a number of allowances exactly equal to verified emissions for the prior year
- Ongoing: account for free allocation received, plan for the following year
The verification requirement is non-negotiable. A third-party accredited verifier must confirm the emissions report before submission. Errors in monitoring data — even small ones — can invalidate the report and trigger penalties. The penalty for a shortfall is €100 per tonne not covered, plus the company must still surrender the missing allowances the following year.
Which sectors and installations the EU ETS covers
Energy, refineries, and heavy industry
The EU ETS covers approximately 10,000 installations across the EU and EEA, representing around 40 to 45 percent of total EU greenhouse gas emissions. Coverage is based on installation type and capacity thresholds, not company size or revenue.
Power generation: all electricity producers and large heat generators above 20 MW thermal input. This is the single largest category, responsible for close to 30 percent of total EU emissions within the system. Free allocation for this sector ended earlier than others; generators have been buying most of their allowances since 2013.
Oil refining: all refineries operating within the EU, regardless of their output volume.
Steel and iron: blast furnaces, electric arc furnaces, and other steel production processes above defined capacity levels. This sector is among the most exposed to carbon cost because emissions are embedded in the production process and difficult to eliminate without process-level transformation.
Aluminium and other metals: primary aluminium smelting and other non-ferrous metal production above capacity thresholds.
Cement and lime: all cement kilns and lime kilns above 500 tonnes of clinker or lime per day. Cement is particularly constrained because approximately half of its process emissions come from the chemical decomposition of limestone, which no efficiency measure can eliminate.
Glass: float glass production and other glass manufacturing processes above specific melting capacity thresholds.
Chemicals: production of nitric acid, adipic acid, glyoxylic acid, and bulk organic chemicals.
Pulp and paper: production above 20 tonnes per day.
Aviation and maritime shipping
Aviation: all intra-EEA commercial flights and departing flights to Switzerland and the United Kingdom are covered. Airlines must surrender allowances for their Scope 1 direct emissions. CORSIA (the Carbon Offsetting and Reduction Scheme for International Aviation) governs intercontinental flights outside the EEA scope. The aviation sector’s free allocation has been reduced significantly since 2023 and will phase out entirely.
Maritime shipping: added to the EU ETS in 2024. The compliance obligations phase in progressively: 40 percent of verified emissions in 2024, 70 percent in 2025, 100 percent from 2026. Full surrender applies to voyages between two EU ports; 50 percent applies to voyages starting or ending outside the EU, and to emissions from ships at berth in EU ports. Companies operating vessels above 5,000 gross tonnage are affected.
Waste incineration: large municipal waste incineration facilities were added to the EU ETS from 2024 under the revised Directive.
How companies receive and manage their allowances
Free allocation: the baseline position
Not all allowances must be purchased. The EU ETS provides free allocation to industries deemed at risk of carbon leakage — the risk that production and associated emissions shift to countries with weaker climate regulation, defeating the purpose of European carbon pricing.
Free allocation is calculated using product benchmarks: the amount of allowances is based on the production volume of the installation multiplied by a benchmark representing the emissions intensity of the top 10 percent most efficient installations in that sector. Companies more efficient than the benchmark effectively receive more free allowances than they need; less-efficient companies receive fewer and must purchase the difference.
The cross-sectoral correction factor has reduced overall free allocation volumes in recent years. From 2026, sectors not on the carbon leakage list receive only 30 percent of their allowances for free; this falls to zero by 2030. Sectors on the leakage list (steel, cement, aluminium, chemicals, paper) retain higher free allocation for longer, but even here the trajectory is downward, with full phase-out by 2034 at the latest.
Auctioning: acquiring allowances on the open market
The primary mechanism for acquiring allowances is the auction. The European Energy Exchange (EEX) and ICE Endex run regular EU ETS auctions throughout the year on behalf of the European Commission and member states. Installations can bid directly or through brokers.
Auction prices track the secondary market closely. The auction clearing price is effectively the spot price at the time of auction. In May 2026, EUAs clear at approximately €79/t. Analysts from multiple institutions forecast a 2026 full-year average of €85/t, driven by a supply reduction of approximately 8 percent versus 2025 under the revised Market Stability Reserve and the Linear Reduction Factor.
Auction revenues are allocated to member states, which are required to dedicate at least 50 percent of proceeds to climate-related purposes: renewable energy, energy efficiency, clean transport, and just transition funding for affected workers and regions.
Secondary market trading and price risk management
Beyond auctions, companies can buy and sell allowances on the secondary market at any time. Major exchanges include ICE and EEX; bilateral over-the-counter trades are also common for larger positions.
Secondary market prices fluctuate based on energy market conditions (gas prices affect power sector demand for allowances), economic activity levels, weather, policy announcements, and investor positioning. Institutional investors — hedge funds, commodity trading advisers, banks — are significant participants. Their aggregate long position in EU carbon futures reached record levels in early 2026, a structural signal that the market expects continued price appreciation.
Companies managing significant ETS exposure typically use a combination of forward purchases, options, and spot buying to smooth their cost profile across the year and across compliance cycles. The decision of when to buy, how far forward to hedge, and how much position risk to carry is a genuine treasury management question at large emitters.
Banking allowances across compliance years
One of the most commercially significant features of the EU ETS is unlimited banking of allowances. A company with surplus allowances in one year — perhaps because production fell or an efficiency project delivered ahead of plan — can carry those allowances forward indefinitely. There is no “use it or lose it” deadline.
Banking enables companies to build a strategic reserve against future price increases or unexpected production surges. It also means that company-level allowance balances are balance-sheet assets, and their mark-to-market value appears in financial statements for installations subject to IAS 20 or IAS 37 accounting treatment.
ETS2: carbon pricing expands to buildings and transport from 2027
What ETS2 covers and who is the regulated entity
ETS2 is a separate, parallel carbon market covering sectors that ETS1 does not reach: road transport fuels, heating fuels for buildings, and small industrial emitters below ETS1 thresholds.
A critical structural difference from ETS1 is where the obligation sits. ETS2 regulates upstream fuel suppliers and distributors, not the end consumers who burn the fuel. A logistics company running a truck fleet will not receive an ETS2 compliance obligation directly; instead, its diesel supplier will. However, the cost will flow downstream through fuel prices, making it effectively impossible for any company with significant road transport or heating costs to avoid.
Sectors effectively reached by ETS2 include:
- All companies operating vehicle fleets (road freight, field sales, company cars)
- Building owners and operators with gas, oil, or coal heating
- Small manufacturers and process industries below ETS1 thresholds
- Construction companies and property developers (energy costs in managed buildings)
Price structure, timeline, and the Social Climate Fund
ETS2 auctions begin in January 2027 to establish market liquidity. The first compliance year — the first year that fuel suppliers must surrender allowances — is 2028, following a one-year delay agreed by EU co-legislators in November 2025.
To prevent price shocks during the early phase, a temporary price ceiling mechanism activates if ETS2 prices exceed €45/t. Once the market matures and the ceiling is lifted, prices are expected to converge toward or above ETS1 levels over time, as the same long-term emissions reduction logic applies.
All ETS2 allowances are auctioned: there is no free allocation. Total ETS2 auction revenue between 2027 and 2032 is estimated at between €184 billion and €483 billion depending on the price path. Twenty-five percent of this revenue feeds directly into the Social Climate Fund (total: €86.7 billion), which will compensate vulnerable households and small businesses for increased heating and transport costs during the transition.
For companies with large building portfolios or fleets, ETS2 creates a second carbon budget that compounds ETS1 obligations. A manufacturing company with covered production processes under ETS1 and a substantial owned vehicle fleet will face carbon costs on both fronts simultaneously from 2028.
Building a practical ETS compliance strategy
Monitoring, reporting, and verification: the non-negotiable foundation
Every ETS1 covered installation must have an approved Monitoring Plan (or Monitoring, Reporting and Verification plan) specifying the methodology for calculating or measuring its emissions. Plans must be submitted to and approved by the national competent authority before the start of each monitoring year.
Two methodologies are permitted: calculation-based (using activity data multiplied by emission factors) and direct continuous emissions measurement (CEMS). Most installations use calculation-based approaches. The precision level required depends on the category of installation and the annual emission volume.
Verification must be completed annually by an accredited independent verifier. The verifier reviews the monitoring methodology, tests the data, and issues one of three opinions: satisfied, satisfied with comments, or not satisfied. Only a “satisfied” opinion allows the emissions report to be submitted and surrenders to proceed. Timing matters: reports are due by 31 March, and submissions from installations with unresolved verification issues face penalties.
Allowance position management: reducing cost and risk
The first step in allowance position management is an annual baseline calculation: expected production volumes for the year, multiplied by site-specific emission factors, minus projected free allocation, equals the allowance shortfall (or surplus) that must be covered through market purchases (or can be sold or banked).
Companies with large shortfalls face both a cost risk (price may rise before purchase) and a liquidity risk (inability to settle compliance positions in time). Typical risk management responses include:
- Forward purchasing: locking in allowances at current prices for future compliance years
- Options strategies: buying call options to cap upside price risk while retaining ability to benefit from price falls
- Systematic monthly purchasing: averaging in to reduce exposure to single-point market risk
- Active monitoring of Market Stability Reserve announcements and policy reviews that affect supply
For companies across the EU and UK simultaneously, the differential between ETS and UK ETS prices adds a currency and market basis risk dimension to position management.
Long-term abatement planning: the strategic use of the carbon price signal
The ETS cap declines by the Linear Reduction Factor (currently 4.3 percent per year for ETS1, rising to 4.4 percent from 2028). This means the cost of holding a fixed emission profile rises automatically every year. Companies that treat the carbon price purely as a compliance cost to be managed, rather than as a capital allocation signal, will face structurally increasing expense with no offset.
The correct strategic response is to model the carbon price trajectory (analyst consensus: €85/t in 2026, >€100/t in 2027, potentially €126/t by 2030) against the internal rate of return of specific abatement investments:
- Fuel switching: replacing gas with green hydrogen or biomethane in industrial processes
- Electrification: replacing fossil-fuel driven equipment with electric alternatives powered by renewable-contracted electricity
- Energy efficiency: heat recovery systems, insulation, process optimisation that reduces energy consumption and thus allowance demand
- Carbon capture: for sectors like cement where process emissions cannot be engineered away, CCS/CCU becomes the primary long-term option
Investments that break even at €80/t carbon should be prioritised today. Investments that break even at €100/t are worth committing to capital planning cycles now. The ETS price path makes the economics increasingly compelling.
CBAM compliance: the supply-chain dimension
The Carbon Border Adjustment Mechanism entered its definitive phase on 1 January 2026. It applies to imports into the EU of steel, cement, aluminium, fertilizers, hydrogen, and electricity. Importers must:
- Register as CBAM declarants in the EU CBAM registry
- Track the embedded carbon in imported goods (verified by an EU-accredited CBAM verifier)
- Purchase CBAM certificates priced at the weekly average EU ETS auction price
- Submit an annual CBAM declaration by 31 May covering the prior year’s imports
- Surrender CBAM certificates equal to the declared embedded emissions by 31 August
The first full compliance cycle (covering 2026 imports) requires declarations by 31 May 2027 and certificate surrender by 31 August 2027. Companies that have not yet mapped their supply chain’s embedded carbon are already behind on data collection for the current reporting year.
The EU-UK carbon market linkage: what the July 13 summit could change
The current price gap and competitive implications
The UK Emissions Trading System, launched in January 2021, was designed as a direct post-Brexit successor to UK participation in the EU ETS. The two systems use similar architecture — cap-and-trade, free allocation, auctions, verified annual reporting — but have diverged meaningfully in price.
In May 2026, the UK ETS trades at approximately £49 per tonne, while the EU ETS is at €79/t. At current exchange rates, this represents a gap of roughly €22/t. For energy-intensive industries, that gap is commercially significant: a UK steel producer faces a carbon cost roughly €22/t lower than an equivalent EU producer on every tonne of steel made. In commodity markets where margins are measured in euros per tonne, this is a structural competitive advantage.
The merger timeline and what a deal would mean
On 19 May 2025, the EU Commission and UK Government committed formally to linking the two systems. The EU Council approved a negotiating mandate in November 2025. Formal technical negotiations began in January 2026. Both sides have confirmed their intent to announce an agreement at the EU-UK summit on 13 July 2026 — though Carbon Pulse reporting from May 2026 notes that progress updates have been “notable by their absence” in recent months.
A successful linkage agreement would:
- Make allowances from either system valid for compliance in the other, creating a single, more liquid carbon market across the Channel
- Drive price convergence: economic equilibrium would push UK prices toward EU levels, eliminating the current €22/t gap
- Trigger a mutual CBAM exemption: the EU has confirmed it will not exempt the UK from CBAM until the systems are formally linked; once linked, UK goods would no longer need CBAM certificates. The UK government estimates CBAM costs £800 million per year for British industry, with £7 billion of UK exports falling within CBAM scope
- Require UK-based companies to remodel their carbon cost base: a £25 to £30/t increase in effective carbon costs across all UK ETS-covered operations
For multinational companies with operations in both jurisdictions, the linkage scenario requires planning now regardless of the July outcome: the direction is toward a larger, more integrated market at higher prices.
How Dcycle helps companies manage ETS obligations
Managing ETS1, preparing for ETS2, and complying with CBAM all depend on the same underlying data capability: granular, verified carbon data by installation, fuel type, process, product, and supply chain tier.
Without this data, companies face a choice between overbuying allowances (to be safe) or scrambling at year-end with incomplete records. Neither is acceptable when allowances cost €79/t and the compliance clock runs to 30 April.
Dcycle provides a centralised platform where companies can:
- Configure ETS monitoring plans digitally and track activity data against approved methodologies in real time
- Calculate embedded carbon in manufactured goods for CBAM declaration, using supplier-specific emission factors where available and industry defaults where not
- Model allowance position scenarios at current and projected carbon prices, integrating free allocation data with production forecasts
- Generate audit-ready annual emissions reports and CBAM declarations in the required regulatory format
- Connect ETS compliance data to CSRD double materiality assessments and ESRS E1 climate disclosure requirements
For more context on how ETS integrates with broader sustainability reporting obligations, see our guides on CSRD carbon disclosure requirements and carbon footprint measurement for industrial sectors.
The window to build compliant, audit-ready data infrastructure ahead of the July summit and the 2027 ETS2 auction start is open now. Talk to our team to understand your specific ETS, ETS2, and CBAM exposure and what a practical compliance roadmap looks like for your operations.