Shrinking EUA supply puts EU ETS under policy strain

Since January, EUA prices have fallen from 90 to 60 €/tCO2e, following uncertainty around EU Emissions Trading System (ETS) reforms. Under current policy, prices could rise as high as 163 €/tCO2e in 2027 according to Fastmarkets Carbon analysis.

This has placed increasing pressure on the European Commission (EC) to enact reforms to the system. This piece sets out how EU ETS design decisions created these conditions, and the options available to the EC to alleviate supply stress while maintaining the ambition of the system to lead EU industry through decarbonisation.

EUA supply pressures are characteristic of the current policy

The EC designed the EU ETS with the intention of an increasingly limited EUA supply placing manageable pressure on EU producers to decarbonise. This means that moving forward, planned policy will reduce both the auctioned and the free allocations released each year, causing a shrinking supply pool of allowances even when carryover from previous years is considered.

Oversupply was historically driven by an excessively high cap for the number of allowances released each year. The EC tightened the cap using the Market Stability Reserve (MSR), which removed allowances from the system, and by changing the linear reduction factor (LRF), which governs the annual reduction in the emissions cap. The LRF increased from 1.74% to 4.3% in 2024. This will continue to compound each year, reducing supply by 16% between this year and 2030, and by 33% up to 2035 under current policy.

Supply will also be affected by the end of the funding stage for the REPowerEU programme. This programme has been funded by €20bn worth of allowances, with auctions expected to conclude by late summer. These allowances were frontloaded from future supply, tightening the market later in the decade.

This shrinking supply pool has been placing upward EUA price pressure in recent years, with EU producers facing the brunt of the cost. Leaders of ten EU nations including Italy, Poland, and Austria recently signed a letter expressing major concerns that the price pressures of the EU ETS could seriously damage EU industry competitiveness. This is despite the implementation of CBAM this year, which aim to protect trade-exposed industrials.

Policy levers to manage tightening supply

The EC is evaluating how they can use policy reform to alleviate these supply strains. These reforms have the potential to protect EU industry by keeping EUA prices relatively flat over the next ten years. Under our analysis, EUA prices could be as low as 88 €/tCO2e in 2035 with reforms, compared to up to 283 €/tCO2e under current policy. Several decisions on potential reforms are expected to be announced this year, as the EC recognises the urgency of addressing this issue. The options available to the EC are explored below.

The EC’s options for short-term relief are limited

The EC is giving the most attention to levers that can provide short-term supply relief. As the tool with the greatest implications for near-term supply, the Market Stability Reserve (MSR) can inject credits into the system when it drops below a certain level. Currently, the lower threshold for the Total Number of Allowances in Circulation (TNAC) sits at 400 million, below which the MSR injects an additional 100 million allowances.

Operating as a similar mechanism to the MSR is Article 29a of the EU ETS. Article 29a provides a discretionary intervention mechanism, triggered when EUA prices exceed 2.4 times their two-year average over a six-month period, which allows the EC to release additional allowances to ease supply constraints.

The MSR will not provide an immediate supply uplift, as Fastmarkets projects that TNAC will not reach its lower threshold until around 2035. The lower threshold was set at this level because the MSR was originally designed to address oversupply. This means that since its inception. In 2019, the MSR has taken allowances out of the market, as the TNAC has been consistently above the 833 million upper threshold. In addition, Article 29a is unlikely to be triggered under recent price movements.

Strengthening these levers could offer relatively quick relief to the fast-approaching supply strains. The EC has proposed to ‘increase the firepower’ of the MSR, which may enable the MSR to be triggered at a higher threshold, or to have the capacity to inject a higher number of allowances. Revisions to the MSR are expected to be proposed in April, with additional reviews on the MSR and Article 29a expected in July and into next year.

Expanding long-term supply

The EU is also assessing levers to relieve long-term supply tightness. Of these, the option with most significant impacts is altering the LRF, the annual reductions of which compound significantly in the long term. Reducing the LRF from 4.3% to 2.71% would increase allowance availability by 137 MtCO2e in 2035. A 2.71% LRF aligns with the EU’s 2040 target, a 90% reduction in emissions relative to 1990 levels.

Delaying the free allocation phase-out would also ease impacts on industry by reducing the effective price paid on emissions. Currently scheduled for 2034, moving total phase-out to 2037 could reduce cost pressures for producers in the next decade. However, this could undermine the carbon cost equivalence underpinning CBAM, which may be undesirable given the international competitiveness concerns and CBAM policy scrutiny.

The EC is also evaluating the inclusion of domestic carbon dioxide removals (CDRs) in the EU ETS, which would have a smaller impact on supply than the two options above due to limited domestic CDR capacity before 2035.

Integrating permanent CDR as fungible ‘negative’ allowances within the EU ETS could boost supply from as early as 2030. High-quality removals from biochar, bioenergy carbon capture and storage (BECCS), and direct air carbon capture and storage (DACCS), are expected to be included first. Other kinds of permanent removals and non-permanent carbon dioxide utilisation are also expected to be evaluated in the July review.

From 2027, these policy levers are expected to expand allowance volumes. While short-term levers can boost volumes significantly in 2027 and 2028, only long-term levers are assumed to consistently increase volumes beyond 2030.

The EC will need to strike the right balance between long- and short-term levers to manage supply and demand levels, while maintaining the decarbonisation ambition of the EU ETS. Upcoming policy reviews provide the European Commission with scope to recalibrate the system. For market participants, upcoming announcements will be critical in shaping price trajectories and subsequent compliance strategies.