Europe’s emissions trading system is an ally, not an enemy, of industrial competitiveness

The European Union’s emissions trading system (ETS) will be reviewed in 2026. A lobbying push to weaken key elements is already underway, particularly from carbon-intensive industries but also from some European governments¹. In response, policymakers must anchor the coming debate with hard evidence of what the ETS has delivered, enabling the review to be a turning point for the ETS to move from a cap-and-trade system to a cap-and-invest² system that will boost Europe’s clean industrial transformation.

The ETS, set up in 2005, covers carbon-intensive industries, electricity generation and intra-European aviation and maritime transport, the greenhouse gas emissions from which amount to about 40 percent of the EU total. The ETS is a central pillar of the European Green Deal, which has already come under significant pressure to soften some policies: the new carbon pricing system for road transport and buildings has been postponed, sustainable finance provisions have been watered down and a 2035 ban on internal combustion engine cars has been made less absolute³. We expect this pressure to continue. 

This analysis explains three elements of the ETS critical to the upcoming review: the system’s effectiveness, the regime of free allocations of carbon permits and the use of revenues from the auctioning of permits.

The ETS reduces emissions efficiently and with limited economic disruption

A large body of empirical evidence shows that the ETS has reduced overall EU emissions by 14-16 percent, relative to a no-policy counterfactual between 2005 and 2020, while having only modest impacts on firm profitability and employment⁴. Emission reductions have been uneven across sectors, with rapid decarbonisation in the power sector and slower progress in carbon-intensive industries (Bayer and Aklin, 2020).

Research underscores the role of expectations in the ETS. Sitarz et al (2024) showed that rising carbon prices partly reflect a shift among market participants from short-termism to more forward-planning, highlighting the importance of credible long-term scarcity signals. In other words, the ETS works not only because it puts a price on carbon today, but because firms believe the ETS emissions cap will continue to tighten. Careful expectation management is essential to preserving the system’s credibility.

Evidence from the early years of the ETS suggests generally modest effects on competitiveness, differing slightly by sector. Productivity gains in Norwegian manufacturing have been partly linked to free allowances (Klemetsen et al, 2020) and French manufacturers have made substantial emissions reductions without losing competitiveness (Colmer et al, 2025).

At the macroeconomic level, assessments point to limited effects of the ETS on GDP and inflation, though impacts differ across countries and sectors. More carbon-intensive economies in central and eastern Europe have experienced relatively larger pressures (Brand et al, 2023; Schotten et al, 2021), highlighting the need for measures such as the EU Modernisation Fund and the EU Just Transition Fund⁵, which provide resources to support the regions most affected by decarbonisation.

Taken together, the ETS has clearly delivered on its core mandate: reducing emissions efficiently with limited economic disruption. The challenge ahead is to preserve this balance as carbon prices rise and abatement shifts to harder-to-decarbonise industrial sectors. 

Generous free allowances under the ETS have failed to foster clean transformation

Since inception, the ETS has had to strike a delicate balance: reducing emissions while preserving the competitiveness of Europe’s most exposed industries. To ensure political and economic viability – and to prevent relocation to jurisdictions with laxer carbon policies (so-called carbon leakage) – free allocation of emission allowances became a central design feature. In a cap-and-trade system, allowances can be auctioned, traded or allocated for free. Free allocation has emerged as the primary way to mitigate carbon leakage risks and to initially build support for the ETS.

ETS Phases I (2005–2007) and II (2008–2012) were dominated by free allocation (Figure 1). Carbon leakage criteria, however, were overly expansive, extending protection beyond genuinely exposed sectors (de Bruyn et al, 2013; ECA, 2020; Martin et al, 2014a, 2014b).

The result was an overallocation of allowances combined with extensive free allocation; until 2012, both the power sector and carbon-intensive industries received free allowances for more than they emitted. Only with the start of Phase III (2013–2020) did auctioning become the default for electricity generation, sharply reducing the volume of free allowances and ultimately creating a binding cap.

Figure 1: Allowance allocation and verified emissions of stationary installations, EU27

^{Source: Bruegel based on EUTL data from European Environment Agency.}

A sectoral breakdown reveals considerable variation in both allowance allocation and cap stringency. Metals, minerals, chemicals and paper firms often received more allowances than verified emissions, generating substantial windfall profits (Figure 2)⁶.

Figure 2: EU allowance allocation and verified emissions by sector, 2005-2024

^{Source: Bruegel based on EUTL data from European Environment Agency. Note: The sectoral breakdown follows the approach proposed by Bayer (2019). Thus, the five sectors are based on the following EU ETS activity codes: ‘Chemicals’: 37-44, ‘Energy’: 20-21, ‘Metals’: 22-28, ‘Minerals’: 29-34, ‘Paper’: 35-36.}

De Bruyn et al (2021) estimated windfall profits for 15 sectors between 2008 and 2019 to range from €26 billion to €46 billion. These were concentrated in iron and steel production and refineries, and unevenly distributed across countries, with Germany, France, Italy and Spain benefitting most. Free allocation has covered over 90 percent of EU industrial emissions, but has not differentiated effectively between sectors in terms of the carbon leakage risks they face, resulting in windfall profits and weaker decarbonisation incentives⁷ (ECA, 2020).

Although industry lobbies for continued free allowance allocation to protect them against carbon leakage and to provide the capital space necessary to finance low-carbon investments⁸, evidence shows that, despite generous free allocation so far, industrial emissions fell by less than nine percent between 2013 and 2022 – far below the nearly 30 percent reduction in the more stringently regulated energy sector^9, 10.

The carbon border adjustment mechanism (CBAM) – the EU’s carbon tariff intended to equalise the carbon price on imports and domestic products – enters into force in 2026 and is set to gradually replace free allocation as the primary tool to protect firms from carbon leakage. Yet, considerable uncertainty remains over whether CBAM will ensure a level playing field, as it does not address competitiveness in export markets and therefore leaves some carbon leakage risks unresolved (Draghi, 2024). This uncertainty is likely to sustain pressure to continue high levels of free allocation for carbon-intensive industries¹¹.

ETS revenues could help finance Europe’s clean industrial transformation, but have been underutilised

Rising carbon prices and the gradual phase-out of free allowances have transformed the ETS revenue landscape. Since 2013, the system has generated over €245 billion in auction revenues for EU governments and initiatives. Annual revenues increased more than five-fold after 2017 (Figure 3), highlighting the growing role auction revenues could play in financing industrial decarbonisation (European Commission, 2025a). In 2024 alone, auction revenues totalled €39 billion, of which more than €24 billion accrued to member states, with the remainder allocated at EU level to the Innovation Fund, the Modernisation Fund and the Recovery and Resilience Facility¹² (European Commission, 2025a).

Figure 3: EU27 auctioning revenues and average annual EU allowance prices, 2013-24

^{Source: Bruegel based on European Environment Agency and ICE. Note: EUA = EU Allowances (carbon permits).}

Under the ETS, EU countries should spend at least 50 percent of auction revenues on climate and energy projects. EU countries are required to report annually on revenue use and have reported an average of 75 percent of auction revenues going to climate-related spending, but these numbers are insufficiently transparent and detailed on actual expenditure (Haase et al, 2022). Although revised rules adopted in 2023 require 100 percent of revenues to be used for climate and energy purposes, and introduce more detailed spending categories, the attribution of spending for climate action remains vague and derogations still allow revenues to be used to compensate carbon-intensive industries for indirect carbon costs¹³.

Germany illustrates these challenges clearly. Its industrial sector accounts for around 20 percent of gross value added – more than in any other EU country¹⁴. In 2023, Germany was the largest beneficiary of ETS auction revenues, receiving over €7.6 billion. Unlike in other countries, these revenues are directed into a special fund, the climate and transition fund (Klima- und Transformationsfonds, KTF), which pools multiple funding sources, with ETS revenues accounting for only about 10 percent. This makes it difficult to trace (Haase et al, 2022). There is even evidence that, in Germany, use of ETS revenues may undermine decarbonisation: up to 30 percent of KTF spending in 2025 was estimated to be detrimental to climate objectives¹⁵, including electricity price compensation for energy-intensive industries (Helak et al, 2025). In 2023 alone, Germany spent around €2.4 billion on energy subsidies to carbon-intensive industries, prioritising short-term price relief over long-term industrial decarbonisation (European Commission, 2025b).

The question remains of whether carbon-intensive industry’s estimated annual investment need, amounting to €34 billion between 2021 and 2030 (European Commission, 2023), can be met by rising auction revenues. At a projected carbon price of around €150 per tonne in 2030¹⁶, and a projected cap of 774 million EU allowances (Umwelt Bundesamt, 2023), auctioning of allowances for energy-intensive industries could generate over €37 billion in revenues in 2030 alone¹⁷, roughly matching the investment need.

A way forward: the ETS as an asset for EU competitiveness 

The ETS has demonstrated that credible long-term carbon pricing reduces emissions at limited economic cost. The 2026 review must reinforce – not weaken – this credibility and align carbon pricing with strategic industrial support to anchor Europe’s decarbonisation pathway. Weakening the system would undermine investment signals and penalise early movers that have already started to decarbonise.

Carbon-intensive industries have benefitted from two decades of free allowance allocation and subsequent windfall profits. Any continuation of free allowance allocation must come with strong conditionality to ensure genuine industrial decarbonisation. Furthermore, maintaining free allocation alongside CBAM would provide double protection, muting decarbonisation incentives and continuing to put the cost of free allocation on society. To preserve the ETS price signal, any extension of free allocation beyond the planned phase-out must link continued protection to measurable progress in industrial transformation¹⁸. Free allocation for carbon-intensive industries should be maintained only in exchange for actual decarbonisation investments.

ETS revenues are among the most powerful tools to finance Europe’s clean industrial transformation. A clear commitment to greater transparency, closer alignment of national revenue use with decarbonisation objectives, and the expansion of EU-level initiatives through the creation of a strong industrial decarbonisation bank to scale up low-carbon investment, can turn the ETS from a cap-and-trade into a cap-and-invest framework. The additional revenues from an increased share of auctioned allowances (see footnote 17) could meet the investment needs of carbon-intensive industries, thereby fostering the clean industrial transformation Europe needs to meet its competitiveness, security and decarbonisation objectives.

Rather than watering down the ETS, policymakers should thus implement three conditions to encourage investment: 1) oblige companies to invest in decarbonisation initiatives to be eligible for free allocation, 2) better align member states’ revenue expenditure with genuine decarbonisation initiatives, and 3) ensure that the EU’s revenue share from auctions is further expanded and used to provide funds for EU-level decarbonisation investment and industrial competitiveness.

The authors are grateful to Ben McWilliams, Georg Zachmann, Alexander Roth, Antoine Mathieu-Collin and Michael Pahle for their useful comments on previous drafts.

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