As part of the European Union’s ambitious climate strategy, the Emissions Trading System (ETS) has long played a critical role in reducing greenhouse gas emissions. With the 2023 revisions to the ETS Directive, a new system—ETS 2—was introduced to specifically regulate CO₂ emissions from fuel combustion in buildings, road transport, and small industrial sectors not covered by the existing ETS 1. As its implementation approaches, stakeholders must understand its design, timeline, and market implications.
Summarizing a recent Market by Market client event, this article provides an overview of ETS 2, including its regulatory framework, market mechanisms, projected impact, and challenges that could shape its future. For additional detail, including pricing forecasts, please contact us to become a ClearBlue subscriber.
Understanding the Scope and Timeline of ETS 2
Unlike ETS 1, which primarily covers large industrial emitters and power generators, ETS 2 takes an upstream regulatory approach. This means that fuel suppliers—not end users—are responsible for monitoring and reporting emissions from the fuels they distribute. The system will operate separately from ETS 1 and is designed to achieve a 42% emissions reduction by 2030 (compared to 2005 levels).
Key Milestones:
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2024–2026: Preparatory phase—entities must report emissions to national authorities.
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2027: Full implementation—regulated fuel suppliers must purchase and surrender emission allowances.
- Potential Delay: If energy prices remain high, ETS 2 may be postponed to 2028. The European Commission will assess this in mid-2026, using indicators such as the average front-month TTF gas price and Brent crude oil price.
The European Commission has set out two specific conditions that could trigger a delay:
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If the average front-month TTF gas price between January 1 and June 30, 2026, is higher than its average price in February and March 2022.
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If the average Brent crude oil price over the same six-month period is more than twice the average price recorded over the previous five years.
Regulated Entities and Allowance Distribution
When first proposed, the European Commission estimated that approximately 11,400 entities across the EU would be regulated under ETS 2. These include:
- 7,000 oil tax warehouses
- 1,400 regional and local gas suppliers
- 3,000 coal suppliers
All emission allowances under ETS 2 will be auctioned, with no free allocation. This is a departure from ETS 1, where free allowances were used to mitigate carbon leakage risks. Since ETS 2 entities can pass compliance costs to consumers, policymakers deemed free allocation unnecessary.
Revenue Allocation and the Social Climate Fund (SCF)
To counteract the financial burden on households, the EU established the Social Climate Fund (SCF). Between 2026 and 2032, the SCF will receive up to EUR 65 billion from ETS 2 revenues, representing about 25% of the total funds generated.
If ETS 2 is postponed to 2028, the SCF’s allocation will be reduced to EUR 54.6 billion. Member States will receive funding based on their 2016–2018 average emissions in the covered sectors. The remaining revenue will be allocated to climate-related projects, particularly in the buildings and transport sectors.
Market Dynamics and Stability Mechanisms
Market Stability Reserve (MSR)
ETS 2 will include an MSR similar to ETS 1 to regulate allowance supply. Key provisions include:
- 600 million allowances will be placed in the MSR at launch.
- If the total number of allowances in circulation (TNAC) exceeds 440 million, 100 million allowances will be moved into the MSR.
- If TNAC falls below 210 million, 100 million allowances will be released.
- On January 1, 2031, all remaining MSR allowances will be invalidated.
Price Control Mechanisms
To curb excessive volatility, ETS 2 includes several price-based intervention mechanisms:
- Price Trigger 1: If the average allowance price exceeds EUR 45 (adjusted for inflation) for two months, 20 million allowances will be released from the MSR.
- Price Trigger 2: Between 2027 and 2028, if the three-month average auction price is 1.5 times the preceding six-month average, 50 million allowances will be released. From 2029, the trigger tightens, requiring the price to be at least 2x the six-month average.
- Price Trigger 3: If the three-month average auction price is three times the previous six-month average, 150 million allowances will be released.
Cap and Auctioning Strategy
At the end of 2024, the European Commission announced the ETS 2 cap for 2027, which will slightly exceed 1 billion allowances. To prevent excessive price volatility at launch, a frontloading mechanism will increase the initial supply by 30%, bringing the total auctioned allowances for 2027 to 1.347 billion.
To offset initial frontloading, auction supply will decrease by 103.6 million allowances annually from 2029 to 2031. The 2028 cap will be set later based on 2024-2026 emissions, with the linear reduction factor increasing to 5.38% from 2028, reducing around 67.4 million allowances per year.
At the same time, ClearBlue Market’s emission reduction projections indicate significant declines across key sectors by 2030. Road transport emissions are expected to fall by 17% to 620 Mt, driven by the adoption of 40 million electric vehicles. In the buildings sector, emissions are projected to decrease by 24% to 287 Mt, supported by the deployment of 50 million heat pumps. Meanwhile, small industry emissions could see a 25% reduction to 131 Mt.
Overall, total emissions are forecasted to decline from 1,303 Mt in 2023 to 989 Mt by 2030. However, as we expect 837 million allowances to be auctioned that year, a shortfall of 151 million allowances is anticipated.
Considering the projected emissions reductions and the implementation of price stability mechanisms, ClearBlue’s base-case scenario anticipates an initial oversupply of allowances in 2027. This surplus is expected to moderate prices, resulting in an average allowance price of approximately EUR 55. However, as the market tightens over time, ClearBlue’s modeling suggests allowance prices could reach nearly EUR 100 by 2030, depending on the scenario.
In a lower-emission scenario, average prices are projected to reach EUR 68 by 2030.
Sectoral Impact: Road Transport and Buildings
Road Transport
A key decarbonization factor for road transport will be electric vehicle (EV) adoption. However, several challenges remain:
- Policy uncertainty: Germany’s abrupt subsidy cuts led to a 28.6% decline in EV sales.
- Biofuel competition: EU renewable energy targets prioritize aviation and maritime biofuels, limiting road transport availability.
- Trade barriers: The EU has imposed tariffs on Chinese-made EVs, ranging from 7.8% to 35.3%, to protect domestic production.
Despite these hurdles, EV sales in Germany are expected to grow from 524,000 (2023) to 2.7 million (2035), with similar trends in France, Italy, and Spain. By 2030, Europe could have 40 million EVs, doubling to 80 million by 2035.
Buildings
Heat pumps are central to the EU’s decarbonization strategy for buildings. However, the market faces both growth opportunities and setbacks:
- EU bans financial incentives for new fossil fuel boilers from 2025, accelerating heat pump adoption.
- Chinese imports are surging, offering models at half the cost of European alternatives, raising concerns about market disruption.
- Government policy shifts: Italy’s heat pump market fell 47% in early 2024 after subsidy cuts, while Germany weakened its heating law due to political pushback.
Nonetheless, total European heat pump installations are expected to rise to 50 million by 2030 and 80 million by 2035.
Challenges and Future Considerations
While ETS 2 is a crucial step in the EU’s climate strategy, several risks remain:
- Affordability concerns: Higher fuel prices could disproportionately impact lower-income households, increasing pressure on the SCF.
- Infrastructure bottlenecks: EV and heat pump adoption require substantial grid upgrades and manufacturing capacity expansion.
- Policy uncertainty: Regulatory changes, such as the potential revision of the 2035 internal combustion engine (ICE) ban, may affect market expectations.
Conclusion
The launch of ETS 2 marks a pivotal evolution in the EU’s emissions trading framework, extending carbon pricing to previously unregulated sectors. By targeting fuel suppliers, ETS 2 creates a streamlined approach to reducing emissions in transport, buildings, and small industries. However, challenges such as price volatility, infrastructure constraints, and shifting policies could influence its effectiveness.
As 2027 approaches, stakeholders must closely monitor policy developments, market conditions, and emission trends. With the right balance of regulation, investment, and consumer adaptation, ETS 2 has the potential to significantly accelerate Europe’s path toward a low-carbon economy.