EU carbon market faces political strain

Debate intensified at a summit of EU heads of state and government last week, where divisions surfaced over how far to adjust the Emissions Trading System, widely regarded as the centrepiece of Europe’s climate policy. European Commission President Ursula von der Leyen defended the integrity of the system while signalling openness to targeted refinements aimed at safeguarding competitiveness.

Created in 2005, the ETS sets a cap on greenhouse gas emissions from power generation, heavy industry and aviation within the European Economic Area. Companies must purchase allowances for each tonne of carbon dioxide they emit, creating a market price for pollution. The cap declines over time, tightening supply and, in theory, driving investment in cleaner technologies.

Carbon prices have fluctuated sharply over the past two years, at times exceeding €90 per tonne before retreating amid slower industrial output and weaker energy demand. While environmental groups argue that price stability is crucial for long-term decarbonisation, several member states have raised concerns about the impact on energy-intensive sectors such as steel, chemicals and cement.

Von der Leyen told leaders that the ETS remains “the most effective and market-based tool” to cut emissions while preserving economic dynamism. At the same time, she acknowledged that external shocks, including geopolitical tensions and volatile energy markets, have complicated the transition for European manufacturers competing globally.

Central to the dispute is whether to alter the pace of allowance reductions or expand mechanisms designed to shield industry from carbon leakage, the risk that companies relocate production to jurisdictions with weaker climate rules. Countries including Poland and some southern member states have called for greater flexibility, arguing that high carbon costs can exacerbate social and economic strains, particularly in regions reliant on fossil fuels.

Germany and France, while supportive of the ETS framework, have also emphasised the need to align climate ambition with industrial policy. Berlin has pressed for accelerated deployment of green hydrogen and state-backed support for heavy industry, while Paris has linked carbon pricing debates to broader questions of strategic autonomy and supply chain resilience.

The Commission has already overseen a significant reform of the ETS as part of the “Fit for 55” legislative package, aimed at cutting net greenhouse gas emissions by at least 55 per cent by 2030 compared with 1990 levels. Revisions agreed in 2023 tightened the emissions cap, extended the system to maritime transport and set the stage for a separate ETS covering buildings and road transport from 2027.

Another pillar of the reform is the Carbon Border Adjustment Mechanism, which began a transitional phase in October 2023. CBAM requires importers of certain goods, including steel and cement, to report embedded emissions, with financial obligations due to begin in 2026. The mechanism is intended to level the playing field between EU producers subject to carbon costs and foreign competitors.

Business groups argue that coordination between the ETS and CBAM remains delicate. Some warn that phasing out free allowances for domestic producers too quickly, while CBAM is still being implemented, could expose companies to unfair competition. Environmental organisations counter that prolonged free allocations weaken the carbon price signal and delay investment in low-carbon technologies.

Financial markets have also become an influential voice in the debate. The EU carbon market has attracted institutional investors and speculators, adding liquidity but also fuelling claims that trading activity can amplify price swings. The European Securities and Markets Authority has examined trading patterns and concluded that the market is functioning broadly as intended, though scrutiny continues.

Economic data have added complexity. Industrial production across parts of the euro area has faced pressure from high energy costs and global demand shifts. Policymakers must balance long-term climate objectives with short-term competitiveness and employment concerns, particularly ahead of European Parliament elections and in an environment of heightened political fragmentation.

Supporters of maintaining the ETS’s current trajectory argue that regulatory certainty is essential. They contend that constant adjustments risk undermining investor confidence in renewable energy, carbon capture and storage, and electrification projects that depend on a credible and rising carbon price.

Critics, however, say that an inflexible approach could erode public support for climate action if households and small businesses feel squeezed by higher costs. The introduction of the second ETS for buildings and road transport has already prompted debate over potential impacts on fuel and heating bills, with the Commission proposing a Social Climate Fund to cushion vulnerable households.