No such thing as a free allowance
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The European Commission is set to publish its EU ETS review on Friday (17th July). While there have been a few notable leaks to the media, the contents of the review remains speculation. Whatever emerges, it's worth remembering that it only marks the start of a long process that will probably carry on well into the latter half of 2027. Time to buckle up for a long ride!
One topic that has been towards the top of the agenda has been free allowances. Reports began to emerge in early February that the Commission was considering a multi-year extension to reduce the burden on European industry. A subsequent panel discussion revealed a preference for extending the availability of free allowances, but "conditional" on firms investing in decarbonisation.
The free allocation of EU emission allowances helps industries that are exposed to carbon leakage meet compliance while remaining competitive against competitors that are not subject to an equivalent carbon price. In principle all industrial installations are eligible for free allocations, except electricity generators and municipal waste incinerators. That doesn't mean they're simply dished out to anyone who pleads poverty though.
The EU ETS Directive establishes different levels of exposure to carbon leakage for the industrial sectors and sub-sectors it covers. Furthermore, the percentage of free allocations that an individual installation is entitled to receive is based on how their carbon intensity compares to a benchmark. For example, those within the top 10% most carbon efficient installation within a particular sub-sector are entitled to 100% of their entitlement.
The EU ETS Directive limits the total amount of allowances that can be distributed free of charge. It requires that 57% of allowances are auctioned. A safeguard mechanism - known as the cross-sectoral correction factor (CSCF) - is triggered when the demand for free allowances exceeds that available. The CSCF subsequently adjusts the number of free allowances distributed to less carbon efficient installations.
Europe's industrial firms have built up a veritable war chest of free allowances. For example, the iron & steel sector has accumulated a surplus of nearly 700 million EU emission allowances (EUAs) during the course of the EU ETS, equivalent to more than 7 years of emissions (based on 2025 levels). Other sectors have also built up vast multi-annual reserves. Many commentators are concerned that this disincentivised companies from making the ground-breaking investments that will really drive down industrial emissions.
The introduction of CBAM was meant to replace the existing system of free allowances. The levy, which was introduced at the start of 2026, will gradually be phased in at the same rate that free allocations for obligated emitters are withdrawn. By 2034 the plan was that importers will have to pay 100% of the CBAM cost, while at the same time no more free allowances would be distributed.
Or at least, that was the plan.
However, since CBAM came into force on 1st January 2026 its become abundantly clear that ensuring a level playing field is a lot more complex. Meanwhile, high energy prices and geopolitical uncertainty has increased pressure on policymakers not to add to the burden already facing Europe's beleaguered manufacturers.
The stakes could not be higher.
More than 90% of announced clean industrial projects in Europe have not yet reached final investment decision (FID) according to data analysed by the Mission Possible Partnership (MPP). In comparison, China accounts for more than 60% of projects that have passed FID over the past two years. As the MPP state China "remains the clearest demonstration of what strategically-coordinated industrial strategy can achieve."
Free allowances are already designed to deliver multiple policy objectives: protecting against carbon leakage, while incentivising individual installations to lower their carbon intensity (the benchmark also becomes increasingly stringent over time, increasing the pressure).
Will expanding the definition of "conditional" allocation of free allowances have the desired effect and lead to an increase in investment in decarbonisation, or will it damage the integrity of the EU carbon price signal, and result in other unintended (and adverse) consequences?
While the provision of free allowances is already somewhat conditional upon a company being active in a certain sector (or sub-sector) exposed to carbon leakage, and their carbon intensity relative to the benchmark, the desire going forward is to make a much clearer link with investment in decarbonisation.
The challenge according to a recent paper published by the think tank EPICO in-conjunction with Frontier Economics is that the definition of "conditional" is ambiguous. The economic case (and whether this ultimately messes with the price signal or not) depends on how such a scheme is designed.
EPICO's report points to one factor in particular that people often fail to appreciate when thinking about free allowances. There's no such thing as free, whether its lunch or emission allowances. Everything has an opportunity cost.
If the cost of decarbonisation is cheaper than the price of emission allowances then a company has an incentive to cut emissions now, and bank the free allowances in preparation for future periods when the carbon price might expected to be higher. The incentive remains the same at the margin whether an emitter gets the allowances for free, or they have to pay for them.
If the conditions for free allowances are too prescriptive, or if they force companies to undertake investments that are not yet commercially viable, the effective level of carbon leakage protection may decline. In the extreme, companies may feel that they are unlikely to receive even baseline level protection against carbon leakage, and so decide to move their production outside of Europe.
On the other hand, make the conditions for free allowances too lenient and it may serve to undermine expectations of a scarcity of allowances, in turn leading to a decline in the EU carbon price. That penalises early movers that have invested in decarbonisation.
Where conditionality might make sense is where it helps unlock efficient decarbonisation measures that companies would otherwise fail to realise. The EPICO paper points to information gaps, organisational barriers or internal prioritisation constraints as potential blockers that could be unlocked.
In short, if an extension to free allocations occurs on a conditional basis, any requirements should reward and protect first movers, while remaining technology agnostic.
If free allowances are to be extended beyond 2034 then its crucial that the Commission addresses their largest opportunity cost: the foregone revenue that would have been generated had those allowances been auctioned, and the clean industrial capacity those funds could have helped accelerate.
For example, less than 10% of the €112 billion of ETS revenues that flowed into national budgets between 2021 and 2024 (around €4 billion) supported industrial decarbonisation, according to estimates by the Jacques Delors Institute.
There's no such thing as a free allowance.
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Peter Sainsbury
