The European Commission planted a carbon bomb in its proposal to reform the supply control mechanism within the EU’s carbon pricing scheme for road transport and buildings. EU decisionmakers meeting on June 10 must mitigate the damage of the proposal and take the chance to increase earmarked funding for vulnerable households in the energy transition

The new Emissions Trading System for road transport and buildings (ETS2) hasn’t had an easy ride since it was first approved in 2023. EU member state governments are far behind schedule in implementing the carbon cutting policy, while policymakers continuously meddle with its design even though it is yet to get up and running. 

During negotiations to set the EU’s 2040 climate target, ETS2 inappropriately became a bargaining chip resulting in its launch becoming delayed by one year to 2028. And while these negotiations were taking place the Commission bowed to significant pressure from member states and proposed a reform of the ETS2’s Market Stability Reserve (MSR2). 

MSR2 operates by adjusting the supply of emission allowances to regulate the ETS2 in response to changing market conditions. When there is an excess supply of allowances, the MSR2 absorbs some from the market, reducing oversupply and stops carbon prices from collapsing. If there is a perceived shortage in the market, the MSR2 releases additional allowances into the market, which lowers prices to below what they otherwise would be. 

In summer 2025, 19 member states signed on to a non-paper addressed to the European Commission expressing concern regarding future price level uncertainties and price volatility in the ETS2 and calling for MSR2 to be reformed. In response the Commission presented a MSR2 proposal that risks adding a carbon bomb of around half a billion additional allowances into the system, putting the achievement of EU climate targets at risk. 

Carbon Market Watch and the LIFE Effect project strongly cautioned against the proposed MSR2 reform. We issued a letter to the Commission outlining the proposal’s climate risks, and published a companion briefing explaining why the MSR2 should have been a non-starter. LIFE Effect partners have advocated to mitigate the climate damage of the proposal, while using the legislative opportunity to improve the social fairness and effectiveness of ETS2 by strengthening the Social Climate Fund and implementing strong complementary national and EU-level policy. 

The European Council and the European Parliament have both finalised their positions on the Commission’s MSR2 proposal, and will now enter trilogue discussions with the European Commission starting on 10 June.

What was the originally agreed MSR2?

The ETS2 legislation outlines that the MSR2 will contain 600 million allowances at the start of the system, serving as an initial extra buffer to limit ETS2 price increases in the first years. It’s important to note that these allowances are additional to the ETS2 pollution cap, meaning that the scheme’s carbon budget could increase significantly if all allowances were released. There is however a provision to limit this risk: A ‘sunset clause’ that means these allowances will automatically expire if unused by 1 January 2031. Under current rules, only a small proportion of the 600 million allowances placed in the MSR2 are expected to be used.

Allowances from MSR2 can be released under certain conditions. Should the Total Number of Allowances in Circulation (TNAC) fall below 210 million allowances, 100 million additional allowances will be released. There are also  price-control mechanisms in operation until 2029 designed to contain early prices. For example a maximum amount of 20 million allowances can be added once per year should the ETS2 price go above €45 (inflation adjusted). When the price control mechanisms expire in 2029, the European Commission is required to report on their functioning, and could propose to extend and expand price controls following their review.

Why the Commission’s proposed reform is bad news

Under pressure from several EU member states the Commission proposed three major changes to the existing legislation that puts the system’s effectiveness at risk and threatens the achievement of EU climate goals.

1) A lower threshold for intervention: This will allow allowances to be released gradually, already when market supply falls below 260 million rather than 210 million allowances.

2) More reactive price control mechanism: If the €45 soft price cap is exceeded, 40 million allowances can be released twice per year, rather than a one off annual injection of 20 million allowances. 

3) Removal of the sunset clause: The 2031 expiry date for the 600 buffer allowances is deleted, allowing this extra reserve supply to exist indefinitely which would permanently increase allowable emissions in ETS2.

These are no small changes to ETS2. The stronger price control mechanisms would mean a quadrupling of possible releases, from 20 to 80 million allowances per year. As the Commission admits themselves, that is more than the required annual ETS2 reduction of 60 million tCO2. This means that emissions could actually increase rather than decrease during the system’s first two years. 

However, the most concerning change is the removal of the sunset clause which would extend the lifetime of the 600 million allowances in the MSR2 reserve indefinitely. By removing the expiry date all 600 allowances would eventually enter ETS2 which is equivalent to 10 years of ETS2 emissions cuts, according to the Commission.

The Commission proposal risks adding a carbon bomb into the system putting EU climate targets at risk, while depressing clean energy investments and reducing the revenue potential for governments to invest in the transition.

Regrettably, the Commission did not respect the Better Regulation guidelines which require new legislative proposals to be accompanied by an impact assessment and a public consultation. By doing so public scrutiny was bypassed and policymakers in the European Parliament and the Council were left to negotiate the file without any official assessment about its impacts.

The MSR2 proposal sets a bad precedent, showing the willingness of the Commission to substantially weaken EU climate policy when put under pressure, without considering responsible due process and the EU’s climate framework and ability to reach EU climate targets as a whole. 

How did the European Council and European Parliament react to the proposal 

The Council was quick to find its position on MSR2 already in February, supporting the Commission proposal, making no changes of their own. In the European Parliament the debate was more extensive. 

MEPs from EPP, S&D, Renew, the Greens/EFA and the Left parliamentary political groupings pushed back against the extensive changes proposed by the Commission and tabled amendments to fully reject or at least mitigate the suggestions. MEPs from S&D, the Greens/EFA and the Left also used the reform as an opportunity to call for changes to increase the social fairness of ETS2 such as increasing the size of the Social Climate Fund (an EU fund developed with the explicit purpose of alleviating potential energy and transport poverty occurring from the transition towards clean mobility, buildings and housing). On the other hand, MEPs from EPP and the far-right party groups ECR, PfE and ESN, tabled amendments seeking to further weaken, delay and even suspend the entire system. 

In the end, the rapporteur for the file, Czech MEP Danuše Nerudová from EPP, managed to find a political agreement in the ENVI committee supported by EPP, Renew, S&D and the Greens. 

Parliamentarians sealed the deal at their April plenary session, with 433 voting in favour, 120 against and 91 abstaining. Importantly, all amendments tabled by ECR and PfE to push the scheme into the long grass – and even cancel it outright – were soundly rejected in plenary (59-65% voting against the AMs). This sends the important political signal from the European Parliament that ETS2 is an important climate policy here to stay.

The good and the bad of the European Parliament position

The good:

• The European Parliament wants to reintroduce an expiry date for the initial 600 million MSR2 allowances. They propose canceling 50% of them in 2034 and the rest in 2036. While this delays the original deadline by five years, it is still better than the European Commission’s plan to remove the deadline entirely.
• MEPs call for more funding and expanding the timeframe for the Social Climate Fund and the Frontloading Facility. This includes encouraging member states to use any revenues generated from auctioning any of the 600 million MSR2 allowances to top-up funding towards the Social Climate Fund and national Social Climate Plans. If all 600 million allowances were to be released and earmarked for this purpose, this could add around €30-40 billion to the fund’s current €86.7 billion limit, thus increasing it by more than a third. However, currently member states are only encouraged to earmark this money on a voluntary basis. Upgrading this suggestion to a binding agreement would guarantee increased support for vulnerable households to switch away from fossil fuels, lowering emissions and helping poorer households through the energy transition. 
• Parliamentarians also call for an impact assessment of the climate impact of the MSR2 changes and for additional policies to be considered to ensure the EU achieves its climate targets, and place a strong emphasis on the importance of complementary policy alongside ETS2.

The bad: 

• The more reactive price control mechanism and earlier intervention of the quantity trigger were left untouched. 
• Despite avoiding the worst case scenario by partially reinstating the sunset clause, the Parliament position still significantly weakens existing legislation by loosening the rules for extra pollution under ETS2.
• The position also calls on the Commission to consider further watering down the MSR2 and allowing a temporary exemption to carbon pricing for residential buildings, which would undercut the effectiveness of the tool.

The discussions ahead

When the European Council, European Commission and European Parliament kick-off formal negotiations on June 10, the improvements in the Parliament’s position must be supported and defended. While it does not go far enough in limiting the negative climate impact of the original proposal, it does mitigate some of the climate damage of the Commission’s proposal, and encourages member states to increase support to citizens through the necessary climate and energy transition.

To preserve the climate integrity of ETS2, we urge policymakers to support at least the partial reinstallment of the sunset clause suggested by the Parliament, which is crucial to prevent all 600 million allowances from flooding the market. Furthermore, conducting an impact assessment on the climate effects of MSR2 changes is crucial. This must be accompanied by complementary EU and member state policies to ensure additional emissions are fully compensated, thus safeguarding EU climate targets.

In parallel, policymakers must enhance the social fairness of ETS2 by expanding and extending both the Social Climate Fund and the Frontloading Facility. This will be critical to enhance support to those who need it most. Crucially, earmarking all revenues from MSR2 allowance auctions must be made mandatory to top up the Social Climate Fund. If extra pollution is to be introduced into the market, at the very least their allowances must be used to deliver a powerful, positive social impact. 

Should policymakers need reminding

Addressing the climate crisis is a necessity to limit its impact on people and nature and policies to wean the EU off fossil fuels have to be enacted. Dependence on fossil fuels has already caused two severe energy price crises since 2022. Even in ‘normal’ years, the EU and its member states spend nearly €400 billion on imported fossil fuels. Since the start of the US and Israeli war on Iran, the EU is spending nearly €500 million extra a day due to fossil fuel price increases. This disproportionately impacts low-income households, who spend a larger share of their incomes on energy bills. 

Climate policies must be implemented in a way that doesn’t leave people behind. Further delay and dilution of ETS2 are shortsighted measures that don’t support people in the energy transition. What will support people is strong targeted support and complementary policy that allow people to break free from expensive fossil fuels and access affordable, clean alternatives. ETS2 will generate hundreds of billions in revenues that can support this cause. The EIB frontloading facility enables member states to already make use of these revenues this year to help households.

It is critical that all member states urgently transpose ETS2 rules and submit strong and inclusive Social Climate Plans. This is the foundation for the policy mix that will ensure a fair and effective energy transition of our road transport and homes.