With the 2027 launch of carbon pricing for road transport and buildings in sight, the LIFE Effect consortium explains why reopening the Market Stability Reserve would be foolhardy, potentially destabilise the Emissions Trading System for road transport and buildings (ETS2), and could make the EU’s climate targets unobtainable

The ETS2 was created to limit carbon emissions in buildings and road transport, and raise revenue for investments in the decarbonisation of our homes and vehicles. As the launch of the ETS2 in 2027 approaches, there is increasing concern over the potential for high ETS2 prices. Carbon prices under ETS2 will rise if emissions are not reduced fast enough. Any ‘complementary’ measures that reduce emissions in ETS2 sectors help to contain the ETS2 price. Many of the higher ETS2 price predictions do not take into consideration the potential for strong complementary measures to drive down the ETS2 price. 

To prevent steep price increases, it’s crucial to introduce and uphold complementary policies – such as CO2 standards for cars and vans and fossil fuel boiler phase-outs as outlined in the Energy Performance of Buildings Directive. National governments have it within their power to make the ETS2 price picture less daunting by undertaking socially and economically beneficial investments using the Social Climate Fund and wider ETS2 revenue to reduce emissions in our homes and road transport.

Stabilising the market

The need for price controls and safeguards was front and centre during the political process to agree the ETS2 legislation between 2021 and 2023. Therefore, the ETS directive and Market Stability Reserve (MSR) already contain several price control mechanisms for ETS2: 

• a ‘soft price cap’ at an inflation adjusted price of approximately €55 per tonne of CO2 (outlined in Article 30h(2))
• the early auctioning of 30% more emission allowances in the first three years
• a market stability reserve which will bring more allowances to the market in case of shortages
• Finally, an additional clause also allows the European Commission to respond to high ETS2 prices by issuing an implementing act if a certain low volume of allowances is met twice within a period of 12 months

These price controls are in place until 2029 when the European Commission is required to report on their functioning, and could propose to extend and expand price controls following their review if needed. 

The importance of complementary measures

Complementary measures can be considered as all of the additional actions to reduce emissions in buildings and road transport on top of the ETS2 price such as the Energy Efficiency Directive, Renewable Energy Directive, Energy Performance of Buildings Directive and CO2 standards for vehicles. 

Complementary measures can also specifically combat the social impacts of ETS2 while lowering emissions such as those within the upcoming Social Climate Fund. To ensure that the ETS2 price increases in a stable manner while maintaining the ability of the system to deliver emissions reductions we must strengthen complementary measures to drive down the demand for ETS2 allowances and thus lower the ETS2 price. National carbon price floors, effectively a nationally determined minimum carbon price, can help provide guidance for investors and avoid countries with high purchasing power and already existing carbon pricing systems such as Germany and Sweden to contribute their fair share of emissions reductions.

If national governments undertake socially and economically beneficial investments to reduce emissions in our homes and road transport, then a high ETS2 price will be avoided. Such efforts are not only necessary, but entirely feasible. Lower and middle income groups without the means to invest in clean alternatives and facing higher energy bills must receive support through investments coupled with direct payments from a share of the €300 billion generated in ETS2 revenue. Member States have the perfect opportunity to outline their approach to social concerns and how they plan on mitigating the potential impact of ETS2 prices, in the National Social Climate Plans which were due by June 2025. However, 26 member states missed this deadline.

The cautionary tale from ETS1

A dangerous approach to addressing high ETS2 prices would be to reform the Market Stability Reserve prematurely –  before the real price signal and emission levels in the market become clear and without considering the environmental implications of the additional allowances that would enter the market and risk exceeding the ETS2 emissions cap. The history of ETS1 has shown us that the oversupply of allowances can lead to an ineffective price signal and stalling emissions reductions. 

Within ETS1 the allowances in the MSR1 were removed from the market as a result of years of oversupply. In contrast, the MSR2 was stocked with allowances in addition to the emissions cap as it was considered that additional market supply  would be needed due to the steepness of the needed emissions reductions. Therefore as the emissions cap for 2027 is set at over one billion allowances, the greater the amount of the additional 600 million allowances in the MSR2 that enter the ETS2 market, the more the level of safe emissions is exceeded for these sectors. 

Rushing to weaken the MSR2 rules before gaining a clear understanding and visibility of the actual ETS2 price endangers the ability of the ETS2 to make its contribution to the fast approaching EU’s 2030 climate target – a 42% reduction in covered emissions – by the end of this decade. Any reduction in the ambition of ETS2 by adding more allowances to the market would need to be compensated by increasing the ambition of the emission reductions in either ETS1 sectors or the remaining ESR sectors; agriculture – which remains politically difficult, or land use sectors where the effectiveness of carbon sinks is already at risk. 

Reopening MSR decision risks weakening climate ambition

The recent non-paper by 16 member states to reform the MSR2 contains several sensible proposals, and the pragmatic approach to addressing concerns related to the ETS2 should be commended. For example, the proposal to publish regular information to inform ETS2 price forecasts and the launch of early auctions in 2026 can both reduce price uncertainty for the start of the system in 2027 and increase the likelihood of early buy-in. 

Updating the threshold effect as was introduced in the ETS1 in 2023 would also reduce the volatility in the market, create a stable carbon price signal, and is a cap-neutral improvement. The recent report by Oeko-Institut, commissioned by CMW, shows that updating the intake rate to 24% of the value of the total number of allowances in circulation (TNAC) and no less than 100M EUAs would suffice. 

However, reopening the MSR decision represents a significant risk to weaken climate ambition particularly in the current political climate where several countries are seeking to roll back climate policy; ETS2 included. In this light, the non-paper includes several suggestions which could have very damaging climate impacts and lead to the evisceration of the system as a meaningful carbon pricing tool.  It is unclear what the implications are of the vague suggestions by member states for the European Commission to consider to ‘strengthen the price cap’ in response to ‘tight market conditions’ as these are subjective and loosely defined terms that reflect an unwillingness to account for the urgent need to steer Europe away from the consumption of polluting fossil fuels. 

Due to the nature of the MSR, the number of allowances in the market can be controlled, but not the resulting allowance price which is determined not only through the supply of allowances but also demand for allowances. Without clarity on what the price levels will be in reality, adding more allowances to the market risks an oversupply and an ineffective price signal. The non-paper focuses strictly on supply side measures for limiting the ETS2 price but stronger complementary measures present a demand side solution that limits prices while driving emissions reductions.

Any measure which increases the number of allowances in the ETS2 market needs to be approached with extreme caution as each additional allowance means one more tonne of pollution in ETS2 sectors and one less tonne which can be polluted in non-ETS sectors to remain within the EU carbon budget. Increasing the volume of allowances released from the MSR2 when a trigger condition is met must come with an accompanying adjustment to remove a proportionate amount of allowances from circulation at a certain later date in order to be ‘cap neutral’ and not push the carbon budget into a deficit. 

Maintaining the sunset clause or the automatic deletion of allowances in 2031 as under threat by the suggestions of the non-paper to reform the MSR2, would protect against the oversupply of allowances in later years. The deletion of the allowances in MSR2 is an essential step to ensure an ETS2 price signal high enough to trigger decarbonisation in the mid to long term.

Let the MSR2 get up and running

Due to the uncertainty around the level of emissions reductions in ETS2 sectors and how well the new market will function, the system should be allowed to operate for a few years before any changes are made to the MSR2. 

Currently, a review of ETS2 is foreseen in 2028 when the Commission must assess the functioning of the market, and again in 2029 when the price control mechanisms are under review. It is advisable to let the ETS2 market function in its initial years with existing price controls, strengthen complementary measures and use the €300 billion in ETS2 revenue to help people to break free from fossil fuels affordably. 

Without maintaining the integrity of the ETS2, the EU risks missing its climate targets.