Policymakers in the European Union have long expressed their commitment to achieving net-zero greenhouse gas emissions. One of the EU’s key instruments to drive decarbonisation is the EU Emissions Trading System (EU ETS), introduced in 2005. Designed as a cap-and-trade mechanism, the ETS sets an overall limit on emissions (in the sectors covered) at the EU level. Companies covered by the system must surrender a tradable allowance (EUA) for each tonne of CO₂-equivalent they emit. Trading allowances means that emissions reductions occur where they are most cost-effective. The price of allowances will be equal to the cost of the most expensive (“marginal”) abatement measure required to ensure the cap is met. 

The ETS currently covers power generation, energy-intensive industry, and – more recently – parts of the aviation and maritime sectors. As part of a broader package of measures at EU and national level, such as subsidies and regulation, the ETS has contributed significantly to the decarbonisation of the covered sectors. 

Over the past years, a series of reforms have strengthened the functioning of the EU ETS. One key improvement was the introduction of banking from Phase 2 (2008–2012) onwards, allowing market participants to carry over unused allowances into future periods. This addressed a major design flaw of Phase 1 (2005–2007), where the inability to bank allowances led to a collapse in prices as surplus allowances lost their value at the end of the period. By enabling banking, the system became more resilient and less prone to price volatility. 

Based on the current “linear reduction factor”, the emissions cap will fall to zero by 2039/2040. From a climate policy perspective, a zero-cap ETS sends a powerful signal of ambition for the sectors covered. However, it brings with it several challenges in the transition:  

• abatement costs may rise steeply in the coming years as effort moves beyond the power sector, which has delivered the bulk of emissions reduction effort to date. While in principle, the ability to “bank” allowances for future periods means today’s allowance prices should in part be based on expectations of future abatement costs, it is unclear whether market participants are fully pricing in the expected trend;  

• a smaller market will be characterised by greater allowance price volatility, all else equal; and 

• perhaps more fundamentally: how can a cap-and-trade system function when there is virtually nothing left to trade? 

The extent to which the level and volatility of the EU ETS price signal affects low-carbon investment decisions will depend on complementary policies. For example, Carbon Contracts for Difference (CCfD) can work alongside the EU ETS to provide carbon price stability from an investor perspective. Such mechanisms are particularly relevant for less mature and cost-intensive decarbonisation technologies. 

Regardless of the importance for investment decisions, until emissions from ETS sectors fall to zero, thin and volatile markets are a potential concern for participants. Participants are able to hedge allowance price risk today using a relatively liquid derivatives market for allowances. If the cost of managing volatility becomes more difficult or more expensive going forwards, this may result in issues for businesses (such as industrials exposed to international trade) that are less able to pass on these costs to customers (and higher costs for customers in other sectors).  

One potential approach to address concerns around market depth is linking the EU ETS with other emissions trading systems. This is not without precedent: the EU ETS is already linked with Switzerland’s scheme, and there has just been an initial agreement on the reconnection with the UK’s scheme (see recent Frontier analysis of the case for a UK-EU ETS link). There is also a discussion ongoing as to whether or not to allow the use of international offsets, which would enable entities to meet part of their compliance obligations by purchasing credits from emissions reduction projects outside the EU, such as through mechanisms under Article 6 of the Paris Agreement. Setting aside the wider pros and cons associated with the use of international offsets, this could increase market depth by broadening the pool of tradable assets and participants, thereby enhancing liquidity. 

Another option is sectoral linking, for instance with the upcoming ETS2 for buildings and road transport, which will launch in 2027. As well as benefits from improved market depth, there may be wider efficiency benefits from a uniform carbon price across sectors. However, to the extent abatement costs vary significantly across sectors, a uniform carbon price could also lead to undesirable distributional effects (i.e. carbon prices higher in linked sectors than they might otherwise have been, leading to additional consumer costs). This could make linking challenging from a social or political point of view. Moreover, while linking sectors can support market depth over the medium term, assuming other sectors also must move towards zero emissions by 2050 at the latest, structural liquidity issues will eventually re-emerge. 

In the longer term, integrating carbon removals (including capture and storage of biogenic emissions, direct air capture, afforestation) into the EU ETS could help ensure its continued viability, and could balance out the CO2 equivalents of residual emissions in hard-to-abate sectors. The European Commission has highlighted the importance of this technology, estimating that around 400 Mt CO₂ equivalents in removals may be required in the EU to reach net-zero economy-wide greenhouse gas emissions by 2050.2  

However, the integration of carbon removals is far from straightforward. While the new Carbon Removals and Carbon Farming Regulation (CRCF)3 provides a certification framework, fundamental questions remain: Should removals be treated as equivalent to avoided emissions or supported by separate incentive mechanisms? How can the permanence of carbon storage (or use) be reliably ensured? Without careful design, the integration of removals in the EU ETS risks undermining both the functionality of the ETS and its environmental integrity. 

A radically different option to mitigate the issues related to a thinning market (until full decarbonisation is achieved) might be a gradual transition to a fixed-price regime or price corridors. However, such a shift would require a rethinking of the EU's institutional framework, as taxation so far remains a prerogative of Member States (and it is an open question whether fixed prices can be structured in a way that avoids classification as a tax). 

The Commission currently has a call for evidence open on potential reforms. Some (such as the inclusion of smaller industrial emitters and smaller vessels) are more “evolutionary”. Others, such as the potential inclusion of permanent carbon removals, or changes to the MSR, would be more consequential. None, however, explicitly address the so-called “endgame”. While 2040 may seem far away, given a combination of legislative timescales and the time horizon over which trading takes place, it is closer than we may realise. More fundamental reform may be needed in the coming years.