EU ETS Phase 5 Proposal: What the 2026 Review Means for Europe's Carbon Market and Global Businesses

On 17 July 2026, the European Commission released its proposal to revise the European Union Emissions Trading System (EU ETS), outlining how the world's largest carbon market could operate throughout Phase 5 (2031-2040).

While the proposal is still subject to negotiations with the European Parliament and Council before becoming law, it provides the clearest indication yet of how Europe intends to balance industrial competitiveness with its long-term climate objectives over the next decade.

Rather than fundamentally redesigning the EU ETS, the proposal seeks to make the system more resilient for the decades ahead. It would slow the decline in emissions allowances, strengthen financial support for industry, integrate permanent carbon removals, introduce a controlled pathway for international carbon credits, and refine market stability mechanisms to support a more gradual industrial transition.

For businesses operating in Europe or trading with the EU, these proposals provide valuable insight into the direction of future carbon policy.

What is the EU ETS?

The European Union Emissions Trading System (EU ETS) is the world's largest cap-and-trade carbon market.

It operates by placing an annual cap on greenhouse gas emissions from covered sectors and issuing a limited number of emissions allowances (EUAs). Companies that emit more than their allocated allowances must purchase additional permits, while those that reduce emissions can sell unused allowances.

As the cap gradually declines, allowances become scarcer, encouraging investment in cleaner technologies and emissions reductions.

Since its launch in 2005, the EU ETS has become one of the world's most mature carbon markets, helping reduce emissions across power generation and energy-intensive industries while establishing a benchmark for carbon pricing globally.

Why was this review needed?

Under the previous Phase 4 trajectory, the supply of new emissions allowances was projected to decline much more rapidly, with analysts expecting the market to become significantly tighter by around 2039.

At the same time, Europe's industrial landscape has changed considerably. Energy price volatility, geopolitical uncertainty, supply chain disruptions, and increasing international competition have placed significant pressure on European industries.

The European Commission therefore faced a difficult policy challenge: "How can Europe continue reducing emissions while ensuring its industries remain globally competitive?"

The review also reflects Europe's broader objective of maintaining an effective carbon market while supporting industrial competitiveness during the transition to a low-carbon economy.

Rather than relying primarily on rising carbon prices to drive emissions reductions, the proposal combines carbon pricing with targeted investment support, industrial incentives, and greater policy certainty.

The result is a more gradual transition that aims to protect industrial competitiveness while maintaining the EU's long-term climate objectives.

Key Changes Proposed

1. A Slower Decline in Emissions Allowances

One of the most significant proposals is a reduction in the Linear Reduction Factor (LRF), which determines how quickly the supply of emissions allowances decreases each year.

The proposal would reduce the LRF to:

• 3.7% between 2031 and 2035

• 1.7% from 2036 onwards

This would extend the availability of emissions allowances well into the 2040s instead of the market becoming significantly tighter around 2039.

Alongside these changes, the proposal would also revise the Market Stability Reserve (MSR), the mechanism that adjusts the supply of allowances entering the market.

The changes aim to reduce excessive market tightening while continuing to support long-term price stability as the EU transitions into Phase 5.

For industry, this provides additional time to transition.

For the market, it could moderate allowance scarcity while maintaining the long-term decarbonisation trajectory.

2. Free Allocation Becomes Performance-Based

Perhaps one of the most significant structural changes is how free emissions allowances are distributed.

Rather than automatically receiving free allocations, operators would need approved decarbonisation investment plans. Under the proposal:

• 80% of free allocation would be linked to approved decarbonisation plans.

• The remaining 20% would depend on implementing those plans and delivering emissions reductions.

The proposal would also extend free allocation for eligible industries until 2038, providing additional time to transition while increasing accountability.

Together, these changes would transform free allocation from a protection mechanism into a performance-based incentive that rewards measurable progress.

3. Carbon Removals Enter the EU ETS

For the first time, the proposal would create a pathway for integrating permanent domestic carbon removals such as Direct Air Carbon Capture and Storage (DACCS) and Bioenergy with Carbon Capture and Storage (BioCCS).

Importantly, companies would not purchase carbon removal credits directly for compliance.

Instead, the European Commission proposes a centralized procurement mechanism where ETS auction revenues would fund the purchase of certified removals.

This approach would seek to maintain market integrity while creating long-term demand for high-quality carbon removal projects.

4. International Article 6 Credits Return in a Controlled Way

The proposal outlines a pathway for incorporating high-integrity Article 6 credits from 2036 onwards.

Unlike earlier phases of the EU ETS, companies would not directly purchase international credits.

Instead, the European Union would establish a centralized purchasing mechanism that procures eligible credits according to strict environmental integrity criteria.

This would reflect a cautious return to international carbon markets with a much stronger emphasis on quality and credibility.

5. Industrial Decarbonisation receives dedicated funding

Alongside carbon pricing, the proposal would establish a new Industrial Decarbonisation Bank. The Bank would provide support through:

• Investment Boosters

• Carbon Contracts for Difference (CCfDs)

• Carbon premiums

These mechanisms are designed to accelerate industrial investment in low-carbon technologies while reducing financial risk for large-scale decarbonisation projects.

More importantly, the proposal signals a broader evolution of the EU ETS, from simply making emissions more expensive to actively financing industrial transition.

6. Better Use of Carbon Market Revenues

The proposal would also strengthen how ETS revenues are reinvested.

Member States would be required to dedicate at least 50% of ETS auction revenues towards climate priorities including industrial decarbonisation, clean energy deployment, electrification, innovation, and research.

This would create a stronger link between carbon pricing and tangible investment in Europe's energy transition.

7. Expansion of the EU ETS

The proposal would expand the scope of the EU ETS to include additional sectors such as:

• Municipal waste incineration

• Broader aviation coverage

• Smaller maritime vessels

Expanding the system would increase market participation while reinforcing the EU's long-term emissions reduction framework.

What does this mean for different market participants?

1. European Manufacturers

Manufacturers would gain additional time to transition through slower allowance reductions and extended free allocation.

However, future support would increasingly depend on demonstrating credible decarbonisation progress, making accurate emissions measurement, investment planning, and reporting more important than ever.

2. Importers under CBAM

Although the proposal provides additional flexibility around free allocation, the long-term direction of the Carbon Border Adjustment Mechanism (CBAM) remains unchanged.

Importers should continue strengthening embedded emissions data, supplier engagement, and carbon reporting capabilities.

3. Carbon Project Developers

Demand for permanent carbon removals and high-integrity international credits could increase significantly over the coming decade.

However, participation would increasingly occur through centralized EU procurement mechanisms rather than direct corporate purchases.

4. Investors

The proposal expands the focus beyond carbon prices alone. Industrial funding mechanisms, carbon removals, infrastructure investment, and policy certainty are likely to become increasingly important drivers of investment decisions.

Sustainiam's Perspective

The proposal reinforces a trend that has been building across global climate policy. Carbon markets are evolving from compliance mechanisms into investment frameworks for industrial transformation.

Future competitiveness will increasingly depend on an organization's ability to generate reliable emissions data, demonstrate measurable decarbonisation progress, and participate in high-integrity environmental markets.

Businesses should begin preparing well before these proposals become law by:

• Building accurate emissions inventories.

• Establishing credible decarbonisation roadmaps.

• Strengthening emissions reporting and data quality.

• Developing long-term strategies for environmental attribute procurement and carbon market participation.

Organizations that invest early in measurement, reporting, and transition planning will be better positioned to access future funding, secure performance-based incentives, and navigate an increasingly sophisticated carbon market.

Conclusion

Although the proposal will undergo negotiations before becoming law, its overall direction is clear.

The EU ETS is evolving from a carbon pricing mechanism into a broader industrial transition framework, one that combines market signals, public investment, carbon removals, international cooperation, and stronger accountability.

For businesses, the question is how quickly they can adapt to a future where credible emissions data, measurable decarbonisation, and transparent reporting become central to long-term competitiveness.

Businesses that begin preparing before Phase 5 is finalized will be better positioned to respond to the final legislation, strengthen their climate strategies, and remain competitive as carbon regulations continue to evolve.