EU ETS 2040 Reform: Brussels Eases Carbon Market Rules

The EU ETS 2040 reform unveiled by the European Commission on 17 July 2026 is one of the most consequential rewrites of Europe’s carbon market since it launched in 2005. The proposal sets the legal framework for Phase 5 of the Emissions Trading System, covering 2031 to 2040, and is designed to align the scheme with the EU’s legally binding target of a 90% net reduction in greenhouse gas emissions by 2040 compared with 1990 levels. The headline number sounds like tougher climate action, and in one sense it is: the ETS already covers roughly 40% of total EU emissions and has helped cut emissions in covered sectors by about 50% since 2005. But the mechanics the Commission chose to get from today’s rules to that 90% target have drawn a sharper reaction than the target itself, with critics arguing the reform quietly loosens the system industry actually has to comply with.

What the Commission Actually Proposed on 17 July 2026

At the centre of the EU ETS 2040 reform package is a change to the Linear Reduction Factor (LRF), the annual rate at which the total supply of carbon allowances shrinks. Under current rules, the LRF is set at 4.3% for 2024-2027 and rises to 4.4% from 2028, a pace that would have pushed the number of available allowances to effectively zero by around 2039. The Commission’s proposal instead sets a shallower LRF of 3.7% for 2031-2035 and just 1.7% from 2036 onward, which permits the EU to keep issuing new allowances well into the 2040s rather than phasing them out entirely. Supporters frame this as a technical adjustment needed to integrate carbon removals into the cap; critics, including POLITICO’s Brussels coverage, describe it more bluntly as allowing industry to keep polluting for longer than previously planned.

Free Allowances Get Tied to Decarbonization Investment

The reform does not simply hand out free pollution permits with no strings attached. Energy-intensive sectors exposed to carbon leakage, such as steel, cement and chemicals, currently receive free allowances through 2030; the new proposal extends that support to 2040, but makes it conditional from 2031 on companies adopting a verified ‘Invest in EU Decarbonisation Plan.’ Under that mechanism, a company must commit to investing the equivalent of 100% of its free allowance value into EU decarbonization projects. In practice, 80% of the free allowances are released once a company’s investment plan is approved, with the remaining 20% released only after the investments are implemented and the resulting emissions cuts are verified. The Commission is also exempting the very best performers: the top 10% of lowest-polluting installations in each sector will not need to prove their green credentials to keep receiving free allowances.

Extended Support for Carbon-Leakage and CBAM Sectors

Sectors already covered by the EU’s Carbon Border Adjustment Mechanism (CBAM), the tariff-like tool that taxes carbon-intensive imports, get their own extension: free allocation for CBAM sectors is pushed out to 2038, several years beyond the original 2030 cut-off, though still subject to the same decarbonization-plan conditions. According to analysis from Global ELR, a separate proposal on ETS heat and fuel benchmarks adopted earlier in the same month is expected to add roughly €6 billion in extra free allocations to industry over 2026-2030 alone. POLITICO also reported the extended CBAM free allocation could invite legal challenges at the World Trade Organization, since it cushions the same sectors the border tax is meant to price fairly against imports.

Carbon Removals Get Folded Into the Cap

A more technical but significant piece of the EU ETS 2040 reform is the integration of permanent carbon removal technologies, specifically bioenergy with carbon capture and storage (BioCCS) and direct air carbon capture and storage (DACCS), directly into the trading system. The Commission proposes purchasing 250 million tonnes of these permanent removals between 2031 and 2040 through a dedicated Commission-run purchasing programme, funded by increasing the number of allowances available for auctioning by 250 million. The idea is that removals count toward the 90% target without displacing the domestic emission cuts industry still has to make, since at least 85% of the 2040 target must come from actual domestic reductions rather than removals or international credits.

Why Critics Call the EU ETS 2040 Reform a Rollback

The clearest sign of how contested this package is comes from the revenue-sharing provision buried inside it: the proposal requires at least 50% of all ETS auction revenue to be returned to ETS-sector companies specifically to fund their own decarbonization investments. That is a meaningful shift for EU member states, which have relied on billions of euros a year in ETS auction proceeds for national budgets, and it is likely to be one of the more contentious lines when the Parliament and Council negotiate the final text. Environmental groups and some lawmakers argue that slowing the LRF, extending free allocation windows, and redirecting carbon-market revenue back to polluters prioritizes industrial competitiveness over the pace of decarbonization, even while the headline 90%-by-2040 target stays formally intact.

What Happens Next

As a Commission proposal, the EU ETS 2040 reform is far from final. It now enters the EU’s ordinary legislative procedure, meaning the European Parliament and the Council, representing the 27 member states, must negotiate amendments and agree on a common text before it becomes binding law, a process that historically takes well over a year for changes of this scale. Because the framework governs Phase 5 starting in 2031, negotiators have a multi-year runway, but industry groups are already pushing to lock in the more generous terms while climate-focused lawmakers will likely push to tighten the LRF trajectory before final adoption.

Limitations of This Reporting

• This is a legislative proposal, not adopted law; the European Parliament and Council can still substantially amend the LRF figures, free-allocation windows and revenue-sharing rules before the reform is finalized.
• Precise figures on how much total free allocation value companies will end up receiving under the new conditional system were not disclosed in the proposal materials reviewed for this article.
• Whether the WTO challenge risk POLITICO flagged around extended CBAM free allocation materializes into an actual dispute is speculative at this stage, not a confirmed legal action.
• This article does not cover ETS2, the separate emissions trading system for buildings and road transport fuels, which the Commission explicitly excluded from this July 2026 review.

FAQ: EU ETS 2040 Reform

What is the EU ETS 2040 reform?

It is a European Commission proposal, published 17 July 2026, that rewrites the rules of the EU Emissions Trading System for 2031-2040 (Phase 5), aligning it with the EU’s target of cutting net greenhouse gas emissions 90% by 2040 versus 1990 levels.

Does the reform make the ETS stricter or looser?

Both, depending on the measure. It formally targets a steeper 90% cut by 2040, but it slows the annual allowance-reduction rate, extends free allocation for industry through 2038-2040, and requires that at least half of ETS revenue flow back to covered companies, which critics say softens near-term pressure on polluters.

When would these changes take effect?

The proposal governs Phase 5 of the ETS starting in 2031, but it must first pass through the EU’s ordinary legislative procedure, requiring agreement between the European Parliament and the Council, a process expected to take well over a year.

Bottom Line

The EU ETS 2040 reform keeps Brussels’ headline climate target intact while rewriting the mechanics that determine how fast industry actually has to cut emissions to get there. A slower Linear Reduction Factor, free allowances extended into the late 2030s, and a mandate that half of carbon-market revenue flow back to polluting sectors together suggest the Commission is betting that a longer runway and stronger investment incentives will do more for industrial competitiveness than a stricter near-term squeeze. Whether the European Parliament and member states agree with that trade-off will determine how much of this proposal survives the legislative process intact.

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