Frontier Economics has published a new study for EPICO KlimaInnovation titled Reform of Free Allocations: Reconciling Carbon Leakage Protection, Investment and ETS Integrity.
The study examines how free allocation conditionality - linking free EU ETS allowances to investment, performance or transformation requirements - can be designed as part of the upcoming EU ETS review without undermining carbon leakage protection or the integrity of the EU's carbon price.
As the ETS cap tightens, CBAM phases in and free allocation for CBAM sectors is gradually withdrawn, pressure on energy-intensive industries is growing. In response, several proposals in the EU debate have called for continued or additional free allocation to be linked more closely to decarbonisation efforts and investment in Europe. However, the term conditionality is used to mean different things across these proposals, from light access requirements to mandatory reinvestment of the value of free allocation.
The study develops an analytical framework to assess these options systematically, comparing them against four criteria:
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whether they preserve carbon leakage protection;
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whether they support efficient decarbonisation and the ETS price signal;
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whether they remain administratively proportionate; and
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whether they protect first movers rather than compensating late movers.
Conditionality is best understood as a second-best safeguard: it cannot restore the ETS scarcity signal if reform lowers expected EUA prices, but used well it can anchor additional flexibility to credible investment incentives, first-mover protection and continued ETS integrity.
Our central conclusion is that conditionality should be proportionate to the level of support provided, not imposed uniformly. Baseline free allocation should not face added conditionality for sectors genuinely exposed to carbon leakage risks; more demanding conditions belong on additional or enhanced support, where they can reward decarbonisation rather than threaten core leakage protection.
This translates into a reform package guided by three principles: the EU ETS price should remain the primary investment signal, baseline carbon leakage protection should stay effective, and conditionality should protect first movers rather than compensate latecomers.
In practice, this means four key recommendations for the upcoming ETS reform package:
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Keep baseline access conditionality light and evidence-based: existing access conditions such as energy audits or Carbon Neutrality Plans should stay in place only where they demonstrate clear value, rather than being tightened by default; requirements that create only procedural compliance without clear impact should be simplified or removed.
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Attach performance conditionality to enhanced support, particularly to protect and reward decarbonisation frontrunners: attaching such conditions to baseline allocation instead risks duplicating the existing benchmark system or penalising installations with limited near-term abatement options. Where possible, additional flexibility for frontrunners should instead be financed from allowances freed up through the CBAM phase-in or from auction shares.
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Avoid use-of-value conditionality: free allocation compensates for carbon-cost exposure rather than functioning as an investment fund, so earmarking obligations would undermine its core purpose. Where investment support is genuinely needed, dedicated instruments such as the Innovation Fund, Carbon Contracts for Difference or the Industrial Decarbonisation Bank are better suited to closing investment gaps.
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Hold consignment in reserve as a contingency safeguard for market liquidity, rather than a central reform proposal: current EUA trading volumes show no sign of a liquidity problem today.
Author
Executive Director
Senior Principal
Principal
10 July 2026
