EU Carbon Prices Face Downside Risk Ahead of ETS Review: Lewis

The European carbon market has turned its focus to the European Commission’s EU ETS review proposal, scheduled to be published on Friday, with many of the opinion that it’s unlikely to be any more bullish for prices than what the market already expects.

The latest OPIS-assessed EU carbon allowance (EUA) price is €79.860/mt. The benchmark December 2026 EUA price has traded in the €72–80/mt range since April. Spanish bank BBVA said in a note published on Monday that it expects market participants to maintain relatively light positioning and favor tactical trading until greater policy clarity emerges.

“The risk here is to the downside more than to the upside,” leading carbon analyst Mark Lewis told OPIS on July 7.

In May, one of the EU ETS architects told OPIS that a €75 EUA price was fair.

“That’s clearly the magic number for the Commission,” Lewis said in response, pointing out that the price appears to be the one used by the Commission to calculate the 400 million EUA Investment Booster, which has been valued at €30 billion, implying a price of €75/mt.

“Therefore, they’re quite happy for prices to come down to €75/mt. I wouldn’t rule out prices coming back to €70/mt over the summer,” he continued.

Once the Commission’s proposal is out, it will be debated by EU member states and the European Parliament over the next 12–18 months, with the resulting changes expected to shape the market well into the 2030s.

Bargaining Chips

“I think the Commission will use some of its proposals as bargaining chips,” said Lewis. He also suggested some Eastern European countries “want to be much more generous” to industry. In contrast, Sweden has called for the linear reduction factor to remain at 4.4% into the early 2030s, according to media reports on Friday. “[A lot] depends on the geopolitical environment and what Europe is facing internationally,” Lewis added.

Given the energy and cost-of-living crises in Europe, the Commission will also face internal political pressure to lower energy prices, according to Lewis. However, “if you are too generous, I think you risk the credibility of the scheme,” he continued.

The Commission has said free allocation benchmarks are designed to reward the most efficient installations in each sector, while support under the Investment Booster will be tied to industrial decarbonization projects and verified emissions reductions. However, according to Lewis, whether that happens or not will be a function of the political pushback in the future.

“But at some point, you really have to make this bite. That’s the whole point of it,” Lewis added.

Linear Reduction Factor (LRF)

The LRF determines how quickly the annual EU ETS cap declines each year. The cap currently falls by 4.3% a year and is set to decline by 4.4% from 2028. Analysts expect the Commission to propose a lower rate from 2031, probably between 3% and 3.4%.

A lower LRF would slow the pace at which the supply of EUAs declines. Lewis said this would not have a large short-term impact, but would loosen the market after 2030 by increasing the total number of allowances available in the 2031–2040 period.

“That would be a very generous increase. Let’s be under no illusions,” Lewis said. “It increases the total amount by between 1 and 1.5 billion metric tons beyond 2030.”

If the proposal features an LRF below 3%, Lewis said that would be a “bearish shock” for EUA prices. He said, however, that most of the additional supply from a lower LRF would come only after 2035, because the gap between the current cap trajectory and a weaker cap trajectory grows over time.

Extra Free Allowances in 2026–2030

According to media reports last week, the proposal would feature fast-tracked changes in the benchmark rules for how many free EUAs the EU gives industries based on heat production and fuel use, resulting in extra free allowances, worth €6 billion. The EUA price dropped more than €2 intraday as a result.

EU member states allocate free allowances to domestic industrial operators in sectors considered difficult to decarbonize, such as steel and oil refining, which could otherwise be placed at a competitive disadvantage compared with imports from countries with no carbon pricing.

Heavy industrial players in the EU have increasingly called for a slowing of the decarbonization targets. Energy-intensive industries argue that carbon costs are rising faster than the technologies and infrastructure needed to decarbonize.

This debate is particularly visible in the steel industry, where larger, more carbon-intensive steelmakers, such as ArcelorMittal Europe, Germany’s Thyssenkrupp and Austria’s Voestalpine, have called for a slower phase-out of free EUAs for industry, while green steel projects and companies that have already invested in decarbonization have called for a strong EU ETS.

“There’s a moral hazard here,” said Lewis. “Companies that have done the right thing […] are effectively being penalized.”

For companies that have already invested in lower-carbon production, a more generous EU ETS could weaken the price signal that justified those investments. Lewis said this could make companies more wary of investing if they believe the rules can be softened again under political pressure.

Market Stability Reserve (MSR)

The Market Stability Reserve is the mechanism that adjusts EUA auction supply depending on the number of allowances in circulation. If the market has too many allowances, the MSR withholds some from auction volumes. If supply becomes too tight, allowances can be released back to the market.

Currently, the MSR has a reserve of 400 million EUAs and cancels out any excess allowances above that level. In March, the Commission proposed to stop invalidating EUAs held in the MSR above 400 million, allowing the reserve to build up a larger volume of allowances. The MSR review will be done at the same time, but Lewis is skeptical if the amendment can be voted on before the end of the year, in which case cancellation above 400 million EUAs will still occur.

Another question in the review is whether the Commission will lower the upper MSR threshold, currently 833 million allowances. However, lowering that threshold could be bullish because it would mean the MSR continues removing allowances from auction volumes for longer.

Investment Booster

The Investment Booster is expected to provide funding for industrial decarbonization. The Commission said in March that the tool will have a budget of €30 billion financed by the sale of 400 million ETS allowances, implying a price of €75/mt.

The key questions are where those allowances will come from, how quickly they will be made available and whether they will be auctioned or allocated directly to companies. Media reports last week suggested the Commission would allocate the allowances directly to industry rather than auctioning them.

The Commission has said the Investment Booster will support industrial decarbonization. But Lewis said the effectiveness of that condition will depend on future political pressure and whether the EU is willing to enforce the carbon price signal over time.

Aviation and Article 6 Credits

Aviation and Article 6 credits are likely to become bargaining points in the negotiations, according to Lewis. The Commission is expected to assess whether the EU ETS should cover more flights to and from Europe, including all flights departing the EU.

Pointing to the reservations of influential countries like Germany and France, Lewis said: “I do think aviation will be proposed, but it won’t make it into the final compromise agreement.”

Finally, Article 6 credits are internationally traded carbon credits created under the Paris Agreement, usually from emissions-cutting or carbon removal projects in one country that can be used by another country or company toward a climate target. Allowing these credits into the EU ETS would let companies use some credits generated outside the EU instead of EUAs for compliance. Lewis said the Commission is probably opposed to allowing Article 6 credits into the EU ETS, but Germany, France and Italy are keen to include them.

The impact would depend on how many credits are allowed and how the EU interprets the 5% international-credit flexibility in its 2040 climate target.

“I certainly think that the LRF – Article 6 tradeoff is going to be one of the most hotly contested issues,” Lewis said.

The International Emissions Trading Association (IETA), a global non-profit business group, has set out a broader post-2030 vision for the EU ETS. In a July 2 paper, it said the post-2030 EU ETS should be part of a wider carbon-market architecture, including international credits, removals and links with other compliance markets.

IETA has backed the use of high-integrity Article 6 credits toward the EU’s 2040 target, a swift EU–U.K. linking agreement, and the possible expansion of carbon pricing to sectors such as waste incineration, rail, inland waterways, off-road machinery and agricultural fuels.

–Reporting by Nia Simeonova, nsimeonova@opisnet.com; Editing by Rob Sheridan, rsheridan@opisnet.com